Research by Riskdata into the behaviour of over 1,000 hedge funds reveals that at least 30% of hedge funds trading illiquid strategies are smoothing returns. Riskdata, the leading provider of risk management solutions to the worldwide alternative investment marketplace, based its analysis on a new indicator called the Bias Ratio that helps in monitoring hedge funds and completing due diligence. The Bias Ratio indicator is incorporated into the latest version of FOFiX, Riskdata’s core risk management application. This new indicator can assist in detecting manipulation of the Net Asset Value (NAV) when illiquid securities are involved. In addition, the Bias Ratio feature can help recognize the presence of illiquid securities where they shouldn’t exist.
Olivier Le Marois, Riskdata’s chief executive officer, commented:
“Our results give strong statistical support to the assumption that the Bias Ratio is an indicator of return smoothing. There is a clear statistical relationship between the liquidity of the strategies and their Bias Ratio. 80% of the high liquidity strategy funds in bucket have a low, statistically insignificant Bias Ratio, while only 3% of the funds running very illiquid strategies are in that position. On the other hand, over 30% of funds trading illiquid strategies such as MBS or ABS have a very high Bias Ratio. So our research confirms that - as a group - funds with illiquid strategies are more likely to be smoothing their returns. Importantly, this does not necessarily imply unfair NAV manipulation, simply that valuation is based on an in house subjective process, rather than on objective process.”
The Bias Ratio indicator was originally created by Adil Abdulali, Risk Manager at Protégé Partners, who developed it through hands-on experience while trading as an MBS trader on the sell side, managing a hedge fund and investing with managers. The Bias Ratio relies on analyzing fund returns to measure how far they are from an unbiased distribution. The Bias Ratio of an equity index will typically be close to 1. On the other hand, the Bias Ratio of a fund that smoothes returns is much higher.
Return smoothing does not necessarily imply unfair NAV manipulation; it simply means that the value is based on an in house subjective process of valuation, rather than on objective process, for example those based on market prices.
Therefore, typically, one should expect that all funds where valuation is based on market price – i.e. trading liquid securities - would have the same range of Bias Ratio (typically close to 1). On the other hand, funds trading highly illiquid securities - where there is high uncertainty on the price - can exhibit very different Bias Ratio, as the manager has some discretion in the valuation process and bias can creep in.
To test these assumptions and give to FOFiX clients a benchmark per strategy, Riskdata’s research team has conducted a review of the Bias Ratio across a sample of 1,011 funds & market indexes. The results are summarized in the chart below. Unsurprisingly, it confirms that as a group, funds with illiquid strategies (such the example involving MBS and ABS) are more likely to be smoothing their returns.
These results support, from a statistical point of view, the assumption that the Bias Ratio is an indicator of return smoothing. There is a clear statistical relationship between the liquidity of the asset universe of the strategies and their Bias Ratio. It is technically very difficult to smooth the returns for strategies dealing with high liquidity, valuation being set by market prices. However, for low liquidity strategies (for example private equity) the return has to be set in based on in house models.
80% of the funds in high liquidity bucket have a Bias Ratio below 2 – i.e. in the range of what is observed for equity market index - while only 3% of the funds running very illiquid strategies are in that case. On the other hand, 53% of funds trading illiquid strategies have a Bias Ratio beyond 5, while only 3% of the funds running very liquid strategies are in that case.
The Bias Ratio of a fund must be interpreted in line with the liquidity of the strategies it is running: what should be considered as abnormal is a Bias Ratio far from the median value observed for the strategy.