An article in the FT this week commented that "hedge fund investors seek shelter from meltdown." The discussion touched on the Bear Stearns' funds, raising the broader question of whether investors do - or can - properly adjust hedge fund returns for illiquidity. In other words, is that nice, smooth "carry trade" return with very low volatility and an exceptionally high Sharpe ratio hiding a risk of significant loss if markets become illiquid?
"Olivier le Marois, chief executive of Paris-based Riskdata, a provider of software solutions that helps asset managers and hedge funds control risk, says that given the potential illiquidity of Bear Stearns’ assets, the funds’ steady returns could have raised a red flag. The reason: in a Riskdata study of 3,216 hedge funds and funds of hedge funds, he found that nearly one-third of funds trading illiquid securities may be smoothing their returns, which could mislead investors about actual underlying turbulence."
"First, thorough due diligence should be made on the valuation process, whether it is performed with in house calculations, vendors software or third parties quotes. Not only should valuations be fair and based on appropriate input data, but all available quotes should be considered without discretionary selection. This point is especially important, due to possible conflicts of interest between managers and brokers about fair valuation when dealing with illiquid securities.
Second, a notable progress in the direction of investors mastering their investments is to give them a quantitative means to detect return smoothing practices. The Bias Ratio – along with Riskdata risk profiling techniques – offers one effective way to alert on possible return smoothing. By itself, quantitative analysis is not sufficient and ought to be supplemented by effective control of managers’ practice. But conversely, quantitative techniques are a necessary add to due diligence and monitoring of investments, as only them can provide an unbiased alert system of managers unfair behaviour.
Third, a complete alarm system should be put in place, which includes not only regular contact with managers, but also a systematic and regular quantitative analysis of their returns, in order to detect biases – like the Bias Ratio – and style drift, as well as to identify sources of risk and potentially hurting scenarios.
Finally, each fund should not only be analysed by itself, but also in the context of a portfolio. For this purpose, the individual risk of one single fund should not hide the risk of diversification – or rather lack of – at the global portfolio level. In other words, this means identifying market scenarios under which investments become correlated and diversification vanishes."