Patterns in returns reported by hedge funds: strategic use of variance and avoidance of reporting small losses

Abstract

This study examines systematic patterns in returns reported by hedge funds for the period from 1989 to 2003. Two patterns are examined: strategic changes in returns variance in the second half of the year and the avoidance of reporting small losses. The hedge fund industry has grown rapidly during the 1990s. Despite this rapid growth, and the large amount of investment in hedge funds, hedge funds are less regulated than other forms of investment. Given the lower level of regulation and the assumed ability of hedge fund managers to influence both investment policy and the estimation of value for illiquid assets included in the calculation of returns, I predict systematic patterns in hedge fund returns. Brown, Goetzmann and Park (2001) show that funds that perform poorly compared to their peers tend to adopt more risk in subsequent periods while funds that perform relatively well tend to adopt less risk. I replicate this result in a larger and more recent database of hedge fund returns. The strategic use of variance is more visible in the latter half of the fifteen year period examined. This result is consistent with increased investor scrutiny and competition between hedge funds in recent years. Burgstahler and Dichev (1997) show that public companies tend to avoid reporting small losses. I show that the well documented discontinuity around zero seen in public company earnings distributions is also found in the distribution of hedge fund returns. This is consistent with hedge fund managers facing similar pressure to public company managers to avoid reporting small losses, and managers having the ability to influence reported returns in a less regulated environment.