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Hedge Funds: Making the Rich Less Rich Morningstar Research | John Rekenthaler

The professors found a number of disturbing tenden- cies with these performance revisions. More of them were down than up. Hedge funds that had at least one performance revision had lower future returns than funds that did not have revisions, with the gap between the two groups being a hefty 3 . 5 percentage points per annum on a risk-adjusted basis. In addition, funds that had a performance revi- sion were likelier to cease operations and liquidate. All this suggests that hedge fund databases provide a new data point: The fund has previously revised a performance number. Fortunately, it is not a data point that is necessary for mutual funds. In addition to having much lower expense ratios than hedge funds, mutual funds rarely revise their past performance figures, and when they do it’s almost always a tiny ad- justment. Receiving bad data is a rich man’s disease. Tail-Chasing FundFire’s headline tells the story: “Wirehouse Advi- sors Drop Hedge Fund of Funds.” Hedge funds of funds, or HFOF s, came into fashion in the middle of the last decade. At that time, hedge funds had ter- rific track records, as most of them had dodged the 2000 - 02 technology stock crash. They were dan- gerous to buy individually, though, because of their investment leverage and their risk of fraud. Thus, the vehicle of choice for institutions and high-net- worth investors became the HFOF , which prom- ised not only to find the best hedge fund managers but also to weed out the frauds. The results have been weak, to say the least. Over the past seven years, multistrategy HFOF s have limped to a 0 . 75% annualized gain in Morningstar’s database. (The official figure overstates the record. As self- reporting entities, hedge funds have the luxury of being able to pick and choose when to divulge their performance. Naturally, they tend to report when doing well and disappear when faring poorly.) In con- trast, every flavor of target-date mutual fund has gained more than 4% over that same time period. Let’s review. Institutions and wealthy informed buyers did their research and selected a high-cost, opaque,

For a while I ran Morningstar’s hedge fund database. And a grim task it was, as hedge funds delight in gaming database providers. Consider one hedge fund that started up in the early 1990 s: “Four months later the fund began reporting to a data- base, and a year after inception it reported assets under management ( AUM ) in the top quintile of all funds. In the mid 2000 s, the fund experienced a troubled quarter and saw its AUM halve in value. It then ceased reporting AUM figures. The fund’s performance recovered, and during the last quarter of 2008 it reported a particularly good double digit return, putting it in the top decile of funds. However, a few months later this high return was revised downward significantly, into a large negative return.” The example and quote come from “Change You Can Believe In? Hedge Fund Data Revisions,” a working paper by professors at Oxford and Duke. As private entities, hedge funds can pick and choose when reporting to databases. They often report to some databases and not others; they release some data points and not others; and they appear and disappear from the databases on terms that the hedge funds find to be favorable. Worst of all, and the paper’s sub- ject, was this: Hedge funds might not report cor- rect performance. In the four-year period from 2007 to 2011 , the pro- fessors found that 49% of hedge funds later revised at least one of the monthly performance figures that they submitted to the database providers. That wouldn’t be of much concern if the revisions were tiny. In some cases they were—only a single basis point. However, 21% of the funds had one or more revisions that were at least a percentage point—a large amount indeed.