Watch Those Hedge Fund Results

February 23, 2001 ( - If you own a certain type of hedge fund, look closely at the performance numbers. You may be better off owning an index fund.

That’s one conclusion from a new study on hedge funds done by some hedge fund managers who have questioned their peers’ use of performance figures.

While the new data has yet to be digested by the industry, and is disputed by some, recent numbers show this select investment group continues to attract the attention of plan sponsors. Hedge funds gained $2.7 billion during the fourth quarter 2000  bringing the total in all hedge funds to about $8 billion, according to Tass Research.

Specifically, the new study by AQR Capital Management, a quantitative management firm in New York, found that some styles of hedge funds which hold specific instruments may suffer from the following problems:

  • Mispricings: Some hedge funds didn’t price some holdings accurately. When the study’s authors reran industry data using a statistical approach which attempts to properly value illiquid securities, they found the average hedge fund captured 84% of the market’s rise. So if the market rose 15%, hedge funds in turn got a 12.6% lift because of the macro-market increase.
  • The upside of illiquidity: The study also found that on days when the market declines, hedge funds may not show any negative results because some of their holdings, such as private equity, don’t trade on that day. While  there is no data on what percentages of hedge fund holdings in equities and fixed income do not trade, the Wall Street Journal quoted a source who put it at 5%. A by-product of this is that a hedge fund may seem less volatile, and less correlated, to the overall market.

The authors of the study, Clifford Asness, AQR’s managing principal, and Robert Krail and John Liew, AQR principals, found that when hedge funds are adjusted for illiquid holdings, these instruments become on average riskier and track the market more closely than they at first appear to do.

Not Industry-Wide Problem

While the study may have found a reporting problem, it may be isolated.

“There may be some grain of truth to the study, but it is very difficult to make a generalizations about the whole industry since there are many funds, such as long-short funds, which trade large cap stocks which do not have an illiquidity problem or trouble obtaining prices,” Ben Borton, portfolio manager, with Hedge Fund Research, Chicago, told

Borton said these problem may be more strategy specific, such as for those funds which trade Regulation D securities and private placements, but it should not become a generalized problem for the whole industry. 

To help rectify the problem of price reporting for some types of hedge funds, Borton recommended that plan sponsors hire a third party price provider who can confirm the validity of prices on a daily basis. A third party pricing service interfaces between the hedge fund manager and the sponsor and independently verifies portfolio prices.