"Even if a fund has a great long-term track record, you have to look at what it is doing," he says. "I won't mention any names, but there is a distressed securities fund that has been doing well for years. The fund is a crapshoot. They will buy, for example, distressed debt from Nicaragua on the Romanian market for 10 cents on the dollar. Next they ask the Nicaraguan government if they would like to buy back their debt for 20 cents on the dollar in pesos. Then the hedge fund will go to a big corporation that is developing property in the country and sell them pesos for 40 cents on the dollar."
Don Goldman, chief financial engineer at Measurisk, a New York-based risk evaluation service, says there are a number of problems with hedge fund data. For example:
There is a danger of misinterpretation or misapplication of the data based on measures of risk.
The amount of assets under management can be distorted because of leverage. You should look for capital under control or capital subject to some form of risk.
Hedge fund performance can be distorted by the fee structure, how security positions are marking to market and how illiquid securities are priced. "Many hedge funds," he said, "do not have the tools to price illiquid securities and depend on the dealers for pricing." Plus many funds of funds are not capable of separate pricing.
Survivorship bias distorts hedge fund data. The data is biased because funds that fail are dropped from the databases. He estimates the hedge fund failure rate ranges between 4% and 25% annually. So the returns on the remaining funds and risk measures have an upward bias. "The bottom line is that when you look at survivors, you see higher Sharpe ratios associated with higher leverage," Goldman said. "Funds might look less risky than they are simply because they are still alive."
Michael Clouser, finance professor at Lynn University in Boca Raton, Fla., suggests reviewing a hedge fund's due diligence report before you start your own investigation. In addition, you should talk to the limited partner of the hedge fund; limited partners in private equity and venture capital deals may talk to investors.
"Unlike their private equity counterparts, most hedge fund managers are unwilling to provide the necessary disclosure on an ongoing basis so that investors feel comfortable," Clouser says.