Return Smoothing and its Implications for Performance Analysis of Hedge Funds

36 Pages Posted: 19 Mar 2009 Last revised: 11 Nov 2012

John Liechty

Pennsylvania State University, University Park

Jing-Zhi Huang

Pennsylvania State University - University Park - Department of Finance

Marco Rossi

Texas A&M

Multiple version iconThere are 2 versions of this paper

Date Written: November 7, 2012

Abstract

Return smoothing and performance persistence are both sources of autocorrelation in hedge fund returns. The practice of pre-processing the data in order to remove smoothing before conducting performance analysis also affects the predictability of hedge fund returns. This paper develops a Bayesian framework for the performance evaluation of hedge funds that simultaneously accounts for smoothing, time-varying performance and factor loadings, and the short-lived nature of reported returns. Simulation evidence reveals that “unsmoothing” predictable, persistent hedge fund returns reduces the ability to detect performance persistence in the second step of the analysis. Empirically, smoothing generates severe biases in standard estimates of abnormal performance, factor loadings, and idiosyncratic volatility. In particular, for funds with high systematic risk, a standard deviation increase in smoothing implies an upward bias in α in excess of 2% annually and a downward bias in equity market beta of more than 20%. For funds with low systematic risk exposure, the smoothing bias is most apparent in estimates of idiosyncratic volatility.

Keywords: Hedge Funds, Smoothing, Performance Persistence, Bayesian Model

JEL Classification: G11, G23, G58

Suggested Citation

Liechty, John and Huang, Jing-Zhi and Rossi, Marco, Return Smoothing and its Implications for Performance Analysis of Hedge Funds (November 7, 2012). Available at SSRN: https://ssrn.com/abstract=1363957 or http://dx.doi.org/10.2139/ssrn.1363957

John Liechty

Pennsylvania State University, University Park ( email )

University Park
State College, PA 16802
United States

Jing-Zhi Jay Huang

Pennsylvania State University - University Park - Department of Finance ( email )

University Park, PA 16802
United States

HOME PAGE: http://www.personal.psu.edu/jxh56

Marco Rossi (Contact Author)

Texas A&M ( email )

360S Wehner
College Station, TX 77843-4218
United States

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