Change You Can Believe In? Hedge Fund Data Revisions

• Published date: 01 June 2015
• DOI: http://doi.org/10.1111/jofi.12240
• Date: 01 June 2015
• Author: TARUN RAMADORAI,ANDREW J. PATTON,MICHAEL STREATFIELD

THE JOURNAL OF FINANCE •VOL. LXX, NO. 3 •JUNE 2015

Change You Can Believe In? Hedge Fund Data

Revisions

ANDREW J. PATTON, TARUN RAMADORAI, and MICHAEL STREATFIELD∗

ABSTRACT

We analyze the reliability of voluntary disclosures of financial information, focusing

on widely-employed publicly-available hedge fund databases. Tracking changes to

statements of historical performance recorded between 2007 and 2011, we find that

historical returns are routinely revised. These revisions are not merely random or

corrections of earlier mistakes; they are partly forecastable by fund characteristics.

Funds that revise their performance histories significantly and predictably underper-

form those that have never revised, suggesting that unreliable disclosures constitute

a valuable source of information for investors. These results speak to current debates

about mandatory disclosures by financial institutions to market regulators.

INJANUARY 2011, THE SECURITIES and Exchange Commission (SEC) proposed

a rule requiring U.S.-based hedge funds to provide regular reports on their

performance, trading positions, and counterparties to a new financial stability

panel established under the Dodd-Frank Act. A modified version of this pro-

posal was voted for in October 2011, and was phased in starting late 2012.

The rule requires detailed quarterly reports (using new Form PF) for 200 or

so large hedge funds, those managing over U.S.$1.5 billion, which collectively

account for over 80% of total hedge fund assets under management (AUM);

for smaller hedge funds, the reports are less detailed, and are required only

annually. The rule states clearly that the reports will only be available to the

regulator, with no provisions regarding reporting to funds’ investors. Never-

theless, hedge funds argued against the adoption of the rule, citing concerns

that the government regulator responsible for collecting the reports could not

guarantee that their contents would not eventually be made public.1

∗Patton is at the Department of Economics, Duke University, and Oxford-Man Institute of

Quantitative Finance. Ramadorai is at Sa¨

ıd Business School, Oxford-Man Institute, and CEPR.

Streatfield is at Sa¨

ıd Business School and Oxford-Man Institute. We thank Michael Brandt, Oliver

Burkart, John Campbell, Evan Dudley,Cam Harvey, Jakub Jurek, Byoung Kang, Robert Kosowski,

Bing Liang, Terry Lyons, Colin Mayer, Narayan Naik, Ludovic Phalippou, Istvan Nagy, Chris

Schwarz, Neil Shephard, and seminar participants at the Oxford-Man Institute of Quantitative

Finance, the Paris Hedge Fund Conference, Sa¨

ıd Business School, Sydney University, UC-San

Diego, UNC-Chapel Hill, and Vanderbilt University for comments and suggestions. Sushant Vale

provided excellent and dedicated research assistance.

1See SEC press releases 2011-23 and 2011-226, available at http://www.sec.gov/news/

press.shtml. For response from the hedge fund industry, see “Hedge Funds Gird to Fight Pro-

posals on Disclosure,” Wall Street Journal, February 3, 2011.

DOI: 10.1111/jofi.12240

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964 The Journal of Finance R

The economic theory literature almost uniformly predicts that providing

more information to consumers is welfare enhancing (an early example is

Stigler (1961); see also Jin and Leslie (2003,2009) and references therein).

Hedge funds, however, are notoriously protective of their proprietary trading

models and positions, and generally disclose only limited information, even

to their own investors. One important piece of information that many hedge

funds do offer to a wider audience is their monthly investment performance.

This information (as well as information on fund characteristics and AUM)2is

self-reported by thousands of individual hedge funds to one or more publicly

available databases. Under the 3(c)1 and 3(c)7 exemptions to the Investment

Company Act, disclosing past performance and fund size to publicly available

databases is thought to be one of the few channels that hedge funds can use to

market themselves to potential new investors (see Jorion and Schwarz (2010),

for example). As a result, these databases are widely used by researchers,

current and prospective investors, and the media.

In this paper, we closely examine hedge fund disclosures to these publicly

available databases, and provide empirical evidence to underpin the current

debate on hedge fund disclosure regulation. We are particularly interested in

whether these voluntary disclosures by hedge funds are reliable guides to their

past performance. We attempt to answer this question by tracking changes to

statements of performance in these databases recorded at different points in

time between 2007 and 2011. In each “vintage” of these databases,3hedge funds

provide information on their performance from the time they began reporting to

the database until the most recent period. We find evidence that, in successive

vintages of these databases, older performance records (going as far back as

15 years) of hedge funds are routinely revised. This behavior is widespread:

49% of the 12,128 hedge funds in our sample revised their previous returns by

at least 0.01% at least once, nearly 30% of funds revised a previous monthly

return by at least 0.5%, and over 20% revised a previous monthly return by at

least 1%. These are very substantial changes, comparable to or exceeding the

average monthly return in our sample period of 0.62%.

While positive revisions are also commonplace, negative revisions are more

common and larger when they occur, that is, on average, initially provided

returns present a more rosy picture of hedge fund performance than final

performance figures. This suggests that prospective investors could be wooed

into making decisions based on initially reported histories that are then sub-

sequently revised. Moreover, the revisions are not random. Indeed, we find

that information on the characteristics and past performance of hedge funds

can predict their propensity to revise. For example, funds-of-hedge-funds and

hedge funds in the Emerging Markets style are significantly more likely to

2Note that the information provided does not include the holdings or trading strategies of the

fund.

3This has links to the “real-time data” literature in macroeconomics; see Croushore (2011)for

a recent survey.

Change You Can Believe In? Hedge Fund Data Revisions 965

revise their histories of returns than Managed Futures funds. Larger funds,

more volatile funds, and less liquid funds are also more likely to revise.

Several characteristics of revising funds suggest the nature of incentives

that may drive revising behavior. For example, a fund experiencing a change

in management company or manager is 10% more likely to revise its past re-

turns, holding all else constant. Following such events, we hypothesize that new

management might be interested in a “fresh start,” revamping the accounting,

marking-to-market, auditing, and compliance practices of their newly acquired

funds, thus resulting in a sequence of revisions to past returns.4Another im-

portant characteristic associated with revising behavior is the presence of a

high-water mark in the fund. Managers may have greater incentives to revise

past returns downwards (or simply to correct previous valuation errors only

in the positive direction) when they are well below their high-water marks, so

as to reset the level at which they begin earning performance fees. Consistent

with this explanation, we find that funds with a high-water mark are 13%

more likely to revise than those without a high-water mark. Moreover, when

funds with a high-water mark revise returns, their average return revision is

−62 basis points. In contrast, funds without a high-water mark provision have

average return revisions of +40 basis points. This allows for a refinement of

our finding that the unconditional average return revision is negative: funds

with an incentive to revise returns below high-water marks revise downwards

on average, whereas funds without high-water marks revise returns upwards,

making past returns appear higher in subsequent revisions.

To provide a concrete example of the sort of revising behavior to which we

refer, consider the (anonymized but true) case of Hedge Fund X, which was

incorporated in the early 1990s. The fund began reporting to a database four

months following inception, and a year after inception it reported AUM in the

top quintile of all funds. In the mid 2000s, the fund experienced a troubled

quarter and saw its AUM halve in value. It then ceased reporting AUM fig-

ures. The fund’s performance recovered, and during the last quarter of 2008

it reported a particularly good double-digit return, putting it in the top decile

of funds. However, a few months later this high return was revised downward

significantly, into a large negative return. A similar pattern emerged later that

year, when a previously reported high return was adjusted substantially down-

ward in a later vintage, along with two other past returns. A further sequence

of poor returns was then revealed, and the fund was finally reported as closed

in mid 2009.

The example provided above suggests that revisions might be useful signals

of fund quality to investors, that is, they may reflect adverse selection problems

embedded in voluntary disclosures of financial information. It is also possible,

of course, that revisions are innocuous despite being systematically associated

with particular fund characteristics. For example, they may simply be correc-

tions of earlier mistakes, and therefore contain no information about future

4While this may be well intentioned, any such changes to preexisting practices may also indicate

the presence of poor preexisting operational controls within the fund.