What does due diligence discover about hedge funds? If outperformance attracts due diligence investigations, does this outperformance persist after the investigations? In the June 2009 draft of their paper entitled “Trust and Delegation”, Stephen Brown, William Goetzmann, Bing Liang and Christopher Schwarz characterize the findings of formal hedge fund due diligence investigations and measure their timing with respect to fund performance. Using a sample of 444 hedge fund due diligence reports (typically 100-200 pages each) from a major hedge fund due diligence firm spanning 2003-2008, along with associated fund performance data, they conclude that:
- 41% of the funds in the sample have a legal or regulatory problem.
- 21% of the funds misrepresent past legal and regulatory problems, and 28% make incorrect or unverifiable representations in other areas.
- Nearly 19% of funds provide asset information that either cannot be independently verified or disagrees with evidence from another source.
- Misrepresentation, the failure to use a major auditing firm and the use of internal asset pricing relate significantly to legal and regulatory problems and operational risk.
- Issuance of due diligence reports typically lags peak fund performance by three months and coincides with peak cash flow into the fund, consistent with return chasing behavior by institutional investors (see chart below.) Also:
- Funds that previously made misrepresentations outperform other funds after the due diligence report, raising the possibility that their managers may be manipulating the return data they report.
- Funds with external asset pricing tend to underperform funds that price their own portfolios, suggesting that external asset pricing provides a check on inflated return reporting.
The following chart, taken from the paper, shows the median return for all funds in the sample from two years before due diligence report issuance (-24) to two years after report issuance (24), with zero being the month of report issuance. Including a lag between report initiation and issuance puts fund selection for due diligence at the peak of fund performance, consistent with evidence that investors (unsuccessfully) chase past performance.
In summary, evidence from hedge fund due diligence reports indicates a substantial level of misrepresentation by fund managers and confirms return chasing by investors. Key indicators of fund manager truthfulness are uses of external asset pricing and a major auditing firm.
