Hedge Fund Manipulation

Happy New Year, everyone! What better way to start the year than highlight rampant fraud?

Hedge funds seem to make all the headlines. Rarely do we hear about plain old mutual funds much anymore. ETFs, derivatives and hedge funds are the investments du jour (or perhaps, “du la decennie” or “of the decade”?) There is a tremendous misunderstanding of what “hedge funds” are, how they invest and what to expect from them. The category is as broad and diverse as the “mutual fund” category is.

Regardless, the first step before putting your money anywhere is to understand how likely it is to be subject to fraud or manipulation. In this department, hedge funds do not shine. A recent paper concludes that many hedge funds “intentionally mismark their stock positions.” You see, any fund must report its value to investors periodically. Whether that be monthly or quarterly, all the funds holdings must be valued and summed on a certain date to arrive at the fund’s value. The change in value from period to period is, obviously, the funds performance. The paper’s authors used SEC filings to determine if those positions were being valued properly. They compared each fund reported their holdings value as with public databases of prices.

Say a fund owns stock of Apple and report to the SEC that as of a certain date (usually quarter end), the fund owns 100,000 shares worth $35,157,000. The author’s compared this value of $351.57 per share with the “official” databases used to price securities by investors everywhere. What they found were striking differences between what the funds reported and the values used by everyone else.

Now, there are several reasons why this could be: a stock could be thinly traded. Advisors are legally allowed to used various methods in determining a price when none is readily available or reasonably accurate. So the authors examined only highly liquid, publically traded investments where pricing is well established (you can’t really argue what the final price for a share of AAPL, IBM or XOM is on a certain date).

What the authors found, was that about 7% of the 2.3million positions examined over a decade showed valuation deviations. Consistent with the assumption of intentional manipulation are the following:

• Even highly liquid positions were regularly mispriced
• Price discrepancies were more likely to show a reporting of returns slightly above zero more often than slightly below zero
• Discrepancies went in the direction of return-smoothing (the great attraction of hedge funds is that their returns are more consistent, which is desirably interpretted as returns with less risk)
• Those funds with significant discrepancies were also those more likely to report smooth returns.
• Those funds with lower probability of getting caught (offshore funds and lesser frequency of audits) showed higher discrepancies.

All in all, the data is consistent with what you would expect if the advisors are being less than forthright. As the paper concludes, “our analysis showed that advisors mismark their stock positions in a way that is consistent with a pursuit of their own interests.”

Since the pricing differential is relatively small when measured accross all fund assets (0.22%), that means that the mispricing is probably eggregious at many funds while others are completely innocent of such an offense. The author’s data could be very valuable in identifying manipulators. More importantly, this should be a warning to investors (though no one seems to ever listen to warnings, they just blame others for their misfortune when no one caught it beforehand). Madoff was obviously a fraud, yet no one cared. There were several highly regarded, supposedly sophisticated, institutions which were feeding Madoff. There were plenty of other supposedly sophisticated institutions which couldn’t identify the risks in time. If the experts can’t do proper due diligence, should you trust their advice? Is your advisor able to do proper due diligence? My advice is to be far more wary than trusting when it comes to non-standard investments (things not traded on exchanges).

Link to the paper

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