Do Hedge Funds Manipulate Their Returns?

In 2011 Vikas Agarwal, Naveen D. Daniel, and Narayan Y. Naik published an academic paper at The Review of Financial Studies titled “Do Hedge Funds Manage Their Reported Returns”? They found evidence supporting their thesis. Here is the abstract of the paper:

For funds with high incentives and more opportunities to inflate returns, we find that (i) returns during December are significantly higher than returns during the rest of the year, even after controlling for risk in both the time series and the cross-section; and (ii) this December spike is greater than for funds with lower incentives and fewer opportunities to inflate returns. These results suggest that hedge funds manage their returns upward in an opportunistic fashion in order to earn higher fees. Finally, we find strong evidence that funds inflate December returns by underreporting returns earlier in the year but only weak evidence that funds borrow from January returns in the following year.

They say what hedge funds do to “manage” their returns is similar to what companies do to “manage” their earnings. Investors prefer hedge funds that have a low percentage of months with negative returns. This is why hedge funds try to smooth their returns.

How do hedge funds manipulate their returns? There are two ways. If they have high returns in earlier parts of the year, they underreport their returns in these months and use them towards the end of the year. The second method they use to manipulate their returns is through last minute buying at the end of December. This practice is often called “portfolio pumping” or “painting the tape”. Here is a chart comparing hedge funds’ December return with their average return during the first 11 months of the year:

Hedge Funds Manipulate Their Returns