Return Smoothing and its Implications for Performance Analysis of Hedge Funds

45 Pages Posted: 18 Mar 2010 Last revised: 21 Mar 2010

See all articles by Jing-Zhi Huang

Jing-Zhi Huang

Pennsylvania State University - University Park - Department of Finance

John Liechty

Pennsylvania State University, University Park

Marco Rossi

Texas A&M

Multiple version iconThere are 2 versions of this paper

Date Written: November 18, 2009

Abstract

Hedge funds often hold illiquid assets whose true value is slowly reflected in reported returns. As a result, reported returns of a hedge fund can become a smoothed version of its true realized returns and, thus, can bias the evaluation of hedge fund performance. To address this problem, we provide a Bayesian framework for the performance evaluation of managed portfolios that accounts for three features of such portfolios: return smoothing; time-variation in performance and factor loadings; and the often short-lived nature of such portfolios. Using simulated data, we estimate several restricted versions of our model and find that return smoothing affects performance evaluation more than the other two features do. We apply the model to a sample of US equity hedge funds over the period January 1994 - December 2005, and find that, even for these relatively liquid strategies, smoothing causes an upward bias in excess performance measures, e.g. the fund's alpha, and a downward bias in risk measures. In particular, we show that a moderate level of smoothing can cause the standard OLS alpha to over-estimate equity funds' abnormal performance by more than 1% annually.

Keywords: Hedge funds, return smoothing, performance persistence, Bayesian analysis, time-varying betas

JEL Classification: C11, G12

Suggested Citation

Huang, Jing-Zhi Jay and Liechty, John and Rossi, Marco, Return Smoothing and its Implications for Performance Analysis of Hedge Funds (November 18, 2009). Available at SSRN: https://ssrn.com/abstract=1571421 or http://dx.doi.org/10.2139/ssrn.1571421

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

John Liechty

Pennsylvania State University, University Park ( email )

University Park
State College, PA 16802
United States

Marco Rossi (Contact Author)

Texas A&M ( email )

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

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