Hedge Funds: Pricing Controls and the Smoothing of Self-Reported Returns

We investigate the extent to which hedge fund managers smooth self-reported returns. In contrast to prior research on the “anomalous” properties of hedge fund returns, we observe the mechanisms used to price the fund's investment positions and report the fund's performance to investors, thereby allowing us to differentiate between asset illiquidity and misreporting-based explanations. We find that funds using less verifiable pricing sources and funds that provide managers with greater discretion in pricing investment positions are more likely to have returns consistent with intentional smoothing. Traditional controls, however, such as removing the manager from the setting and reporting of the fund's net asset value and the use of reputable auditors and administrators, are not associated with lower levels of smoothing. With respect to asset illiquidity versus misreporting, investment style and portfolio characteristics explain 14.0–24.3% of the variation in our smoothing measures, and pricing controls explain an additional 4.1–8.8%, suggesting that asset illiquidity is the major factor driving the anomalous properties of self-reported hedge fund returns.