Are hedge funds honest?: an NYU study

The short answer is–not so much.

The study results:  one in five hedge funds misrepresent themselves to investors

The study, led by Prof. Stephen Brown of NYU, looked data on 444 hedge funds complied by a hedge fund due diligence firm,   The researchers found that about a fifth of hedge fund managers misrepresented themselves to the due diligence firm–even though they knew HFDD had been hired by potential clients to verify all the statements the hedge funds made.

In particular:

–in 21% of the cases, hedge funds misrepresented prior legal or regulatory problems,

–in 15% of the cases, failed to disclose some or all of their prior legal or regulatory difficulties,

–in 28% of the cases, hedge funds provided incorrect or unverifiable assertions about assets under management, performance or other investment issues,

20% of the managers lied to HFDD during interviews ( the researchers euphemistically call this “bad recall”),  that is, they misstated either their performance, assets under management or their own experience or education.

Liars talk big and then fail

The study found that firms where HFDD detected misrepresentation tended to report better investment performance their peers  (No surprise here.  If someone is going to lie, why would they say the results were bad). They also tended to be more likely to fail.

The biggest indicators of possible trouble…

The only clear indicator of potential problems that the academic researchers found was not having a Big 4 auditor (think:  Madoff or Stanford).  There were other, less statistically significant, signs, as well.  Suspect firms tended to price their assets themselves and to switch support services frequently (presumably because the incumbent support firms had discovered misrepresentation and wouldn’t tolerate it).

…and of “clean” firms

Non-problem firms tended to have several common characteristics:  their results were priced by a third party, they were audited by a Big 4 accounting firm, and they kept the same support vendors for long periods of time.

Investors typically hired HFDD in several instances…

Clients normally asked for a HFDD report when a hedge fund was large, had a record of superior performance, charged high fees or didn’t have a Big 4 auditor.

…but the reports made no difference in whether clients invested or not…

The study shows that making false statements in the due diligence process didn’t deter investor interest or slow down flows of new money into a hedge fund.  One exception:  having a manager exhibit “bad recall” in an interview was a negative.

..and clients invested at just the wrong time.

Previous studies have shown that the bulk of the superior performance for most hedge funds comes in their formative years, when they are trying to make a name for themselves and attract clients.  By the time money comes rolling in, however, the best days for performance are already gone.  This study shows the same thing.  Clients request the due diligence studies right at the zenith of fund performance and of money inflows.  The chart in the NYU study that shows performance for the two years following a due diligence investigation goes straight downhill.

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