Research by Riskdata into the behaviour of over 1,000 hedge funds reveals that at least 30 percent 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.
“Our results give strong statistical support to the assumption that the Bias Ratio is an indicator of return smoothing. 80 percent of the high liquidity strategy funds in bucket have a low, statistically insignificant Bias Ratio, while only 3 percent of the funds running very illiquid strategies are in that position. On the other hand, over 30 percent 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.” says, Olivier Le Marois, Riskdata’s chief executive officer.
The Bias Ratio indicator was originally created by Adil Abdulali, Risk Manager at Protg 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. 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.
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.