Not only did several high-profile hedge fund managers such as John Paulson have a tough year in 2011, it now appears that performance data for the entire industry is being called into question.
Research indicates that the aggregate data used by hedge funds to justify their performance edge has been systematically inflated or manipulated, writes James Saft in an article published by Reuters. He cites a study by academics Adam L. Aiken, Christopher P. Clifford and Jesse Ellis which indicates that the hedge fund industry may be over-reporting its returns to investors.
The reason is that participating in hedge fund indices, which are used to tout performance and attract investors, is entirely voluntary. This means that well-known hedge fund benchmarks may overestimate returns for the industry, because poor-performing funds can simply choose not to submit their statistics.
“The industry is like a poker player who tells you about his big wins, but changes the subject to sports when he’s on a losing streak,” writes Saft.
What’s more, the hedge fund industry claims that funds regularly rack up 3 to 5 percent of “alpha” on top of market-driven beta, on a risk-adjusted basis, but may be spurious as well. By adjusting for the self-selecting behavior mentioned above, the study authors calculate that most funds generate an alpha of only 0.20 percent annually.
“Rather than fund managers having the ability to consistently deliver superior risk-adjusted returns, it appears that much of the previously documented skill of hedge fund managers can be explained by the upwardly biased returns data employed by researchers,” the study authors concluded.
All this points to a major challenge for hedge fund marketers in 2012. Not only will you have to contend with disappointing returns from last year. You will have to work doubly hard to counter the arguments being made against the hedge fund value proposition, and prove to current and new investors that participating your fund does in fact justify the added expense.