Risk Indicator Detects When Hedge Funds Trading Illiquid Securities Are Smoothing Returns

With the near collapse of two hedge funds last month at Bear Stearns Asset Management from investments in complex mortgage backed securities, risk management experts are pointing out the hazards of valuing illiquid securities. Recent research by Riskdata, into a sample of over 1,000 hedge funds reveals that at least 30 percent of hedge funds trading illiquid strategies are smoothing returns.Smoothing means "instead of following a mark-to-market process to price securities based on what the market is giving for the securities, they are implementing a subjective process of evaluation," says Olivier Le Marois, Riskdata's CEO in an interview.

According to Le Marois, at the end of the day, the portfolio manager itself decides what is the value of the securities he is trading. The opposite approach would be to have an objective process of evaluation done by a third party, such as a fund administrator. When a fund is smoothing its returns, "If the fund is forced to liquidate its securities, you find that there is an opportunist valuation of securities compared to what the market is willing to pay for them," the CEO says.

The analysis is based on a new indicator called the Bias Ratio, which helps institutional investors monitor hedge fund returns and detect possible smoothing. The new indicator can also detect manipulation of the net asset value (NAV) when illiquid securities are involved and can recognize the presence of illiquid securities when they shouldn't exist, according to the release. Protégé Partners, a client of Riskdata, originally developed the Bias ratio and Riskdata is distributing the indicator through its FOFiX risk management application, According to the release, the Bias Ratio analyzes the fund returns to measure how far they are from an unbiased distribution. While the Bias Ratio of an equity index will typically be close to one, the Bias Ratio of a fund that invests in illiquid securities is much higher.

According to the research, 80 percent of the funds in the high liquidity bucket have a Bias Ratio below 2, while only 3 percent of the funds running very illiquid strategies are in that case. However, 53 percent of fund trading illiquid strategies have a Bias Ratio beyond 5, while only 3 percent of the funds running very liquid strategies are in that vicinity.

The study was based on sample of hedge funds for each strategy, including convertible arbitrage, fixed income, multi-strategy, MBS/ABS, distressed, event driven, small/micro cap and emerging markets, among others. The hedge funds in the database are representative of the weighting of the overall hedge fund community and some of the fund returns go back 10 years, says Le Marois.

One reason for smoothing returns is to reduce volatility. Comparing the situation to a landscape with high mountains and deep valleys, when someone "is in the mountain they use these high returns to fill the valley to give the users the view that it's smooth," says Le Marois. "You think it's not risky, when in fact, it's very risk because it's been smoothed," he warns, adding this gives institutional investors an artificial sense of security.

In Bear Stearns' case, the hedge funds (which reportedly invested in illiquid securities backed by subprime mortgages) had a smooth track record with no volatility, until the first bad month, March of this year, says Le Marois. "These funds had a Bias Ratio of 16 so it positioned them among the 30 percent of funds that had a very high Bias Ratio," he says. The study confirmed that as a group, funds with illiquid strategies, (involving MBS and ABS), are more likely to be smoothing their returns.

If hedge funds that invest in illiquid securities have smooth returns, the Bias Ratio can send a warning that this can be very artificial," he notes. Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio