One in three funds trading illiquid securities smoothes returns, says Riskdata

At least 30 per cent of hedge funds trading illiquid strategies are smoothing returns, according to research into the behaviour of more than 1,000 hedge funds conducted by Riskdata, a provider of risk management solutions to the alternative investment marketplace.

Riskdata's analysis is based on a new indicator called the Bias Ratio that helps in monitoring hedge funds and completing due diligence and is incorporated into the latest version of FOFiX, Riskdata's core risk management application.

The Bias Ratio indicator can assist in detecting manipulation of a fund's net asset value when illiquid securities are involved, as well as in recognising the presence of illiquid securities where they shouldn't be present.

'Our results give strong statistical support to the assumption that the Bias Ratio is an indicator of return smoothing,' says Riskdata chief executive Olivier Le Marois. 'There is a clear statistical relationship between the liquidity of the strategies and their Bias Ratio: 80 per cent of the high liquidity strategy funds [surveyed] have a low, statistically insignificant Bias Ratio, while only 3 per cent of the funds running very illiquid strategies are in that position.

'On the other hand, more than 30 per cent of funds trading illiquid strategies such as mortgage-backed or asset-backed securities have a very high Bias Ratio, so our research confirms that - as a group - funds with illiquid strategies are more likely to smooth their returns.'

The Bias Ratio indicator was originally created by Adil Abdulali, a risk manager at Protégé Partners who developed it through hands-on experience while trading as a mortgage-backed securities trader on the sell side, managing a hedge fund and investing with managers.

The Bias Ratio analyses fund returns to measure how far they are from an unbiased distribution. The ratio of an equity index will typically be close to 1, while that of a fund that smoothes returns is much higher.

Le Marois says return smoothing does not necessarily imply unfair NAV manipulation, but simply means that the value is based on an in-house subjective process of valuation, rather than on an objective process such as one based on market prices.
Therefore one should expect that all funds where valuation is based on market price, that is, trading liquid securities, would have the same range of Bias Ratio, typically close to 1).

By contrast, 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 provide FOFiX clients with a benchmark per strategy, Riskdata's research team has conducted a review of the Bias Ratio across a sample of 1,011 funds and market indexes. The results confirm that as a group, funds with illiquid strategies are more likely to be smoothing their returns and 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 strategies and their Bias Ratio. It is technically very difficult to smooth the returns for strategies dealing with high liquidity because valuation is set by market prices. However, for low liquidity strategies such as private equity, the return has to be set in based on in-house models.

Four-fifths of the high liquidity funds surveyed have a Bias Ratio below 2, in the range observed for equity market indices, compared with 3 per cent of the funds running very illiquid strategies are in that case. By contrast, 53 per cent of funds trading illiquid strategies have a Bias Ratio higher than 5, but only 3 per cent of the funds running very liquid strategies.

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