Some Hedge Fund Managers Don't Tell the Truth

(MoneyWatch)  When writing The Only Guide to Alternative Investments You'll Ever Need, I placed hedge funds in the bad category. And that was before I saw a report about how one in five hedge fund managers misrepresent their fund or its performance. (To say nothing of worse behavior, such as the alleged insider trading that led to the recent arrest of hedge-fund manager Raj Rajaratnam.)

According to the Financial Times, New York University's Stern School of Business reviewed 444 due diligence reports written between 2003 and 2008 and compared hedge fund manager claims to actual data. The study covered funds with up to $8 billion in assets and managers with an average of almost 20 years experience. Thus, the data captures some of the most prominent hedge funds in operation.

They found that managers most commonly misrepresented the amount of money they had entrusted to their funds, their performance and their regulatory and legal histories. In one case, a hedge fund manager overstated the fund's assets under management by $300 million.

As well as analyzing the occurrence of falsehoods, the Stern School sought to gauge the severity of the problem and its implications. Researchers looked specifically at instances where funds had been in some form of regulatory or legal trouble in the past and found that nearly one in six managers either underplayed or denied the existence of such problems. The researchers found that one fund had lied about the legal records of its partners, as the fund's two founders both had criminal records.

When I ultimately settled on placing hedge funds in the bad category for my book, I had a number of reasons. I believe you should avoid them because:

• There's no evidence of persistent outperformance beyond the randomly expected.
• Their risk-adjusted returns have been similar to Treasury bills.
• Their returns exhibit negative skewness and excess kurtosis -- traits investors prefer to avoid because they create the opportunity for large losses.
• They're highly illiquid due to lock up periods in the contracts.
• They're generally tax inefficient.
• They lack transparency, so investors lose control of risk.
• Their incentive structure creates agency risk -- the risk the manager will act in their interest, not yours.

I'm beginning to think I wasn't a tough enough critic.