Opacity, Stale Pricing, Extreme Bounds Analysis, and Hedge Fund Performance: Making Sense of Reported Hedge Fund Returns

The purpose of this chapter is to critically evaluate the methods used to examine hedge fund performance, review and synthesize studies that attempt to explain the inconsistencies associated with the performance of hedge funds and to attempt to compare the returns of hedge funds against more liquid investments. In fact, research related to hedge fund performance seems to have been focused on whether hedge fund managers manipulate their performance and what investors should think about this performance manipulation; however, recent studies have questioned whether this perceived performance manipulation is manipulation per se or something else. In general, researchers have used a number of different techniques to attempt to model hedge fund performance and the relative opacity and latency that is evident in the reporting of hedge fund returns. Nevertheless, the very nature of the structure of a hedge fund makes it difficult to mark the returns to market on a frequent basis and even if managers wanted their performance marked to market, which would unveil their positioning through time, the relative illiquidity and stale pricing associated with some of the investments that are held by hedge funds make pricing the hedge fund a difficult and somewhat pointless exercise. To this end, studies that attempt to analyze and evaluate aggregate performance for hedge fund returns have focused on identifying the true determinates of hedge fund performance, attempted to account for and explain the relative staleness of pricing in hedge fund returns, and to relate the performance of hedge funds to more liquid and transparent investments. This chapter offers key suggestions for financial market participants such as hedge funds managers, portfolio managers, risk managers, regulatory bodies, financial analysts, and investors about their evaluation and interpretation of hedge fund performance. In addition, this critical review chapter can benefit investors, portfolio managers, and researchers in the establishment of a yardstick for the assessment of hedge fund performance and the performance of assets that have stale pricing and are relatively opaque.