Return Smoothing Research Articles

A Screen for Fraudulent Return Smoothing in the Hedge Fund Industry

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.

Return Smoothing Mechanisms in Life and Pension Insurance: Path-Dependent Contingent Claims

Traditional with-profits pension saving schemes have been criticized for their opacity, plagued by embedded options and guarantees, and have recently created enormous problems for the solvency of the life insurance and pension industry. This has fueled creativity in the industry's product development departments, and this paper analyzes a representative member of a family of new pension schemes that have been introduced in the new millennium to alleviate these problems. The complete transparency of the new scheme's smoothing mechanism means that it can be analyzed using contingent claims pricing theory. We explore the properties of this pension scheme in detail and find that in terms of market value, smoothing is an illusion, but also that the return smoothing mechanism implies a dynamic asset allocation strategy which corresponds with traditional pension saving advice and the recommendations of state-of-the-art dynamic portfolio choice models.

An econometric model of serial correlation and illiquidity in hedge fund returns

The returns to hedge funds and other alternative investments are often highly serially correlated. In this paper, we explore several sources of such serial correlation and show that the most likely explanation is illiquidity exposure and smoothed returns. We propose an econometric model of return smoothing and develop estimators for the smoothing profile as well as a smoothing-adjusted Sharpe ratio. For a sample of 908 hedge funds drawn from the TASS database, we show that our estimated smoothing coefficients vary considerably across hedge-fund style categories and may be a useful proxy for quantifying illiquidity exposure.

Hedge Fund Risk Factors and Value at Risk of Credit Trading Strategies

This paper analyzes the risk characteristics for various hedge fund strategies specializing in fixed income instruments. Because fixed income hedge fund strategies have exceptionally high autocorrelations in reported returns and this is taken as evidence of return smoothing, we first develop a method to completely eliminate any order of autocorrelation process across a wide array of time series processes. Once this is complete, we determine the underlying risk factors to the true hedge fund returns and examine the incremental benefit attained from using nonlinear payoffs relative to the more traditional linear factors. For a great many of the hedge fund indices we find the strongest risk factor to be equivalent to a short put position on high-yield debt. In general, we find a moderate benefit to using the nonlinear risk factors in terms of the ability to explain reported returns. However, in some cases this fit is not stable even over the in-sample period. Finally, we examine the benefit to using various factor structures for estimating the value-at-risk of the hedge funds. We find, in general, that using nonlinear factors slightly increases the estimated downside risk levels of the hedge funds due to their option-like payoff structures.

Take (smoothed) risks when you are young, not when you are old: How to get the best from your pension plan

Using stochastic modelling, we demonstrate that the best investment strategy for the accumulation phase of a defined contribution pension plan is one that limits the range of returns that are credited to the plan member's account. In particular, we show that with‐profit accumulation programmes which make use of a smoothing fund to smooth out returns over time dominate unit‐linked accumulation programmes. However, for the distribution phase, we show that it is hard in practice for an investment‐linked distribution programme to beat the income and security provided by a standard annuity, although we again find that, by avoiding extremely poor outcomes, with‐profit distribution programmes dominate unit‐linked distribution programmes. Return smoothing by means of a smoothing fund is therefore a valuable feature of any long‐term investment programme both during the accumulation and distribution phases.

21-hydroxylase deficiency families with HLA identical affected and unaffected sibs.

During our investigations of polymorphisms at, and in the immediate chromosomal vicinity of, the 21-hydroxylase locus in families with 21-hydroxylase deficiency, three families were found to show marked discordance in clinical features of HLA identical subjects. In one family, there is discordance between a boy with the simple virilising form of 21-hydroxylase deficiency and his two younger sisters, who are both HLA identical to their brother, but who have additional salt wasting features. In the other two families, one subject is severely affected and has very high 17-hydroxyprogesterone levels, but has an HLA identical sib who is asymptomatic and shows only slightly raised 17-hydroxyprogesterone levels. In all cases, HLA identity, as indicated by protein polymorphism studies (HLA-A, B, DR, C4A, C4B, and Bf typing), has been verified at the gene organisation level using 21-hydroxylase and complement C4 DNA probes. An HLA-Bw47 bearing haplotype in one of the latter families has not been transmitted to the affected child and appears to carry a normal 21-OHB allele and two genes which specify C4A allotypes.