Hedge funds come unstuck on twisted truths, lies

Has the hedge-fund industry been built on a series of lies?

For the past decade, its explosive growth has been based on a simple claim: that skilled money managers, motivated by high performance fees, could outperform the market when it was going up "" and sidestep the trouble when it was going down.

And yet the credit crunch has shown that to be a myth. Although a few hedge-fund managers have done brilliantly, far more have come unstuck.

Now it looks as if the industry might be based on a more systematic falsehood. Two recent academic studies suggest that hedge funds have been routinely dishonest, or at least economical with the truth.

If that's right, then it is worrying for alternative-asset managers. As the idea gets out that hedge funds can't deliver the kind of guaranteed returns they promised, a lot of money is heading for the door marked exit.

There is no questioning the gloom surrounding a once-booming industry. Almost every day brings news of another fund stumbling. More than a dozen big hedge funds have shut up shop, frozen redemptions or been forced to find outside capital this year as markets turned volatile.

Peloton Partners LLP liquidated its largest fund after making bets on mortgage securities that turned sour, while JWM Partners LLC, run by former Long-Term Capital Management LP chief John Meriwether, was hurt by swings in Japanese government bonds.

Overall, hedge funds turned in their worse quarterly performance in six years, according to Chicago-based Hedge Fund Research.

Distorted returns
Everyone knows that the markets go down as well as up. There isn't any investment that makes money every year. The hedge funds were bound to go through a bad patch. But what if the funds have been distorting the truth?

Veronika Krepely Pool, assistant professor of finance at Indiana University in Bloomington, Indiana, and Nicolas Bollen, associate professor of finance at Vanderbilt University in Nashville, Tennessee, examined how hedge funds reported to their investors over several years.

Although the funds often scored a gain of 1 percent a month, they rarely reported a loss of the same amount. "We estimate that approximately 10 per cent of returns in the database we use are distorted," they concluded. "This suggests that misreporting returns is a widespread phenomenon."

Of course, you can understand why that might be happening. It's embarrassing to own up to losing money when you have promised investors you will make a profit.

The difference between losing 0.1 per cent and making 0.1 per cent might not add up to much in money terms. Yet in terms of presentation it can be crucial. You might excuse that as a small lie.

The trouble with small lies, however, is that they lead to bigger ones. A report from Wharton School of the University of Pennsylvania suggests dishonesty on a greater scale.

Statistics Professor Dean Foster and Brookings Institution Senior Fellow H. Peyton Young said it is easy for hedge funds to start up and make money without having any real investment skills.