Return Analysis

A common calculation method of Hedge Fund Return (within hedge funds) is the compound average growth formula, abbreviated to CAGR.

Note that the Compound Average Growth Rate states “Value”, but is not specific as to which valuation system calculates that value. It can be obtained using a variety of methods. Market value, discounted cash flow, dividend discount model, adjusted present value, Black-Scholes-Merton, and other valuation models are all options for determining value. Some funds run multiple valuations on the same investment asset. Once an investment team reports a return using a specific model’s result in their CAGR formula, ensure further results are calculated using the same valuation model. This is only one of many concerns when reading return reports.

Hedge Fund Return: Manipulating Returns

Returns are partially selectable, as well as susceptible to fraud. Hedge fund managers can modify appearances by changing how they select valuation models and reporting dates. There are several ways a hedge fund’s return can be manipulated during its initial calculation.

Fund managers can select dates that improve performance. By ending the quarter on a day that was better than average, starting the quarter on a day that was worse, or both, they can silently boost results. They can also select the investment range to hide issues. When reducing losses managers may increase a reported quarter’s length to a date where baseline prices are closer to the prices at the end of the quarter. The prices would be farther apart when using the same technique to exaggerate gains. They may even skip releasing reports for the quarter, hoping the next quarter’s prices will be more favorable for fund reports. Make sure managers are using the same investment date range and not adjusting period lengths to boost appearances.

Managers can also manipulate investment values to adjust performance appearances. By inconsistently switching the valuation model used to judge asset’s worth, they can improve the appearance of results. They have higher leeway with certain investments than others, such as illiquid or difficult to sell assets. The current value of those investments can be estimated using any one of several valuation models. They can sell underperforming or poorly projected assets before creating asset lists, adjusting the fund’s risk level.

These techniques are used to hide mistakes and exaggerate a manager’s lack of investment skill. Successful managers will not have to engage in reporting tactics. Be suspicious of funds you believe are changing standards before formulating their reports. One way to avoid manipulated reports is by ensuring the fund is regularly audited by a certified accounting firm. Ensure this firm has no other conflicts of interest with the fund. Be wary of hedge funds which are either unaudited or audited by uncertified accountants. You should avoid funds audited by accounting firms with a clear conflict of interest. The most blatant example is hedge funds with a partial or total ownership of the auditor or the auditor’s parent company. Personal relationships, such as family members, romantic partners, or longtime associates may also be conflicts of interest. If you believe it is likely these issues are occurring, exit the fund. You do not need to be invested with people who lie to you, especially if they are compromising the professional standards of employees to accomplish their lies.

Hedge Fund Return: Reported Returns versus Your Returns

The reported hedge fund return is different from your after fees return. Hedge funds usually do not show returns with fees deducted for a simple reason: different members may pay different costs. Investors, especially those with high deposits, can negotiate different aspects of their fund investment. This results in differing pay structures, which makes it somewhat pointless to report fees net of costs. If the fund’s reporting is gross, then investors may subtract their own fees. If the fund’s reporting is net, be sure you pay the same fee structure as the report’s deductions. If your investment classification differs from normal investors, add back the effect of costs and then subtract your personal cost level from the returns.