Hedge Fund Return Misreporting: Incentives and Effects

Abstract:     
Hedge funds commonly misreport returns by overstating their reported performance. We study the conditions that affect hedge fund managers' propensity to misreport and the effects of misreporting on performance measurement and investment decisions. First, misreporting is most prevalent in large funds, in funds that have strongly performance-dependent flows, and during months of positive capital flows. These empirical findings are consistent with a simple model where hedge fund managers have three motives to misreport returns: charging a higher management fee, attraction of larger capital flows in the future, and wealth transfer from the new investors to the old investors in the fund. Second, misreporting smooths returns, decreases the estimates of risks, and increases estimates of risk-adjusted returns. Finally, misreporting affects investors' decisions: misreporting funds receive higher capital flows.

Number of Pages in PDF File: 28

Keywords: Hedge Funds, Return Misreporting, Incentives, Performance measurement, Fund flows

JEL Classification: G23

working papers series