Are voluntary hedge fund disclosures reliable?

Despite the miles of column inches devoted to the hedge fund industry in the financial and popular press, relatively little is known about their trading strategies, risk profiles, liquidity needs, or potential for impact on systemic risk. In the wake of the recent financial crisis, the Securities and Exchange Commission proposed a rule requiring US-based hedge funds to provide regular reports on their performance, trading positions, and counterparties to a new financial stability panel established under the Dodd-Frank Act. A modified version of this proposal will be phased in starting late this year, and requires detailed quarterly reports for 200 or so large hedge funds (those managing over $1.5 billion) and less detailed, annual, reports for smaller hedge funds. The proposal makes clear that these reports would only be available to the regulator, with no provisions in the proposal regarding reporting to funds' investors. Nevertheless, hedge funds argued against the proposal, concerned that the regulator collecting the reports could not guarantee that they would not eventually be made public.

One significant disclosure that hedge funds offer to a wider audience is reports of their monthly investment performance. This self-reported information is provided by thousands of individual hedge funds to one or more publicly available databases, which are widely used by researchers, current and prospective investors, and the media. As SEC rules preclude advertising by hedge funds, these performance disclosures (as well as disclosures on fund size and a few other fund characteristics) are considered to be one of the few ways that hedge funds market themselves to potential new investors (see Jorion and Schwarz 2010 for example).

In a recent CEPR Discussion Paper (Patton et al 2012), we carefully examine hedge fund disclosures to these publicly available databases. We ask whether these voluntary disclosures by hedge funds are reliable guides to their past performance and attempt to answer this question by tracking changes to statements of performance in ‘vintages’ of these databases recorded at different points in time between 2007 and 2011. In each such ‘vintage’, hedge funds provide information on their performance from the time they began reporting to the database until the most recent period.

We find that in successive vintages of these databases, older performance records (pertaining to periods as far back as fifteen years) of hedge funds are routinely revised. This behaviour is widespread: nearly 40% of the 18,382 hedge funds in our sample have revised their previous returns by at least 0.01% at least once, and over 15% of funds have revised a previous monthly return by at least 1% (see Table 1 below). These are very substantial changes, given the average monthly return in our sample period of 0.64%.

Table 1. Size of revisions

We are careful to check whether these revisions are potentially attributable to corrections of data entry errors (such as sign errors or digit transpositions). However, we find that such potential corrections account for less than 8% of the revisions, meaning that 92% of the revisions are attributable to something other than innocuous errors.

We also study the ‘age’ of the return that was revised. If the return initially reported by a hedge fund manager was an estimate, perhaps based on an estimated valuation for an illiquid investment, then it might be reasonable to expect subsequent revisions of the initially reported return. To evaluate this explanation, we report the age of the revised return, and find that around a quarter of the revisions that we identify relate to returns that are less than three months old (see Table 2 below). However, we also find that almost one half of all revisions relate to returns that are more than 12 months old.

Table 2. Age of revised returns

Investigating the pattern of revisions more thoroughly, we find both positive and negative revisions in our sample. However, negative revisions are more common and larger when they occur, ie, on average, initially provided returns present a rosier picture of hedge fund performance than finally revised performance (see Figure 1 below). This suggests the danger of prospective investors being wooed into making decisions based on initially reported histories, which are then subsequently revised. Moreover, these revisions are not random; indeed, we employ information on the characteristics and past performance of hedge funds to predict them. For example, Funds-of-Funds and hedge funds in the emerging-markets style are significantly more likely to have revised their histories of returns relative to security selection funds. Larger funds, more volatile funds, and less liquid funds are also more likely to revise.

Figure 1. Cumulative differences between ‘true’ and initial returns

Finally, to understand whether there is any predictive content to knowing that a fund has revised its history of returns, we analyse the out-of-sample performance of revising and non-revising funds. At each vintage of data, we categorise hedge funds into those that have revised their return histories at least once (revisers) and the remainder (non-revisers). Following the performance of these funds in the future, we find that non-revising funds significantly outperform revising funds. The magnitude of the average out-performance is around 25 basis points a month, and is not explained by differences in exposures to various factors that previous researchers have used to explain hedge fund returns (see Table 3 below, which includes risk adjustment as in Fung and Hsieh 2001). This finding suggests that while there may be several innocuous reasons for revising past returns, it nevertheless constitutes a negative signal about the future performance of the fund.

Table 3. Return differences between non-revisers and revisers

Recent policy debates on the pros and cons of imposing stricter reporting requirements on hedge funds have raised various arguments. The benefits of disclosures include market regulators having a better view on systemic risks in financial markets, and investors and regulators being able to better determine the true, risk-adjusted performance of funds. Costs include the administrative burden of preparing such reports, and the risk of leakage of valuable proprietary information on trading strategies that may be backed out from portfolio holdings. Our analysis suggests that mandatory, audited disclosures by hedge funds, such as those proposed by the SEC last year and due to be implemented in 2012, would be beneficial to regulators. Our analysis additionally suggests that it would be worth considering whether these reporting guidelines, which currently only apply to funds' disclosures to regulators, could also apply to disclosures to prospective and current investors. Our analysis suggests that such information would help hedge fund investors make more informed investment decisions.