A Screen for Fraudulent Return Smoothing in the Hedge Fund Industry

Abstract:     
This paper constructs a statistical screen for fraudulent return smoothing in the hedge fund industry. We show that if true returns are independently distributed, and a manager fully reports gains but delays reporting losses, then reported hedge fund returns will feature conditional serial correlation. Simulation evidence indicates that the power of the screen is restricted by the limited histories of some funds, but may still be sufficient to deter fraudulent return smoothing. Empirical evidence shows that the probability of observing conditional serial correlation is related to the volatility and magnitude of investor cash flows, consistent with managerial smoothing in response to the risk of capital flight.

Number of Pages in PDF File: 51

Keywords: Hedge funds, fraud

JEL Classification: G23, G28

working papers series