The Bias Ratio As A Hedge Fund Fraud Indicator: An Empirical Performance Study Under Different Economic Conditions

Abstract

The Sharpe ratio is widely used as a performance evaluation measure for traditional (i.e., long only) investment funds as well as less-conventional funds such as hedge funds. Based on meanvariance theory, the Sharpe ratio only considers the first two moments of return distributions, so hedge funds -characterised by complex, asymmetric, highly-skewed returns with non-negligible higher moments -may be misdiagnosed in terms of performance. The Sharpe ratio is also susceptible to manipulation and estimation error. These drawbacks have demonstrated the need for augmented measures, or, in some cases, replacement fund performance metrics. Over the period January 2000 to December 2011 the monthly returns of 184 international long/short (equity) hedge funds with investment mandates that span the geographical areas of North America, Europe, and Asia were examined. This study compares results obtained using the Sharpe ratio (in which returns are assumed to be serially uncorrelated) with those obtained using a technique which does account for serial return correlation. Standard techniques for annualising Sharpe ratios, based on monthly estimators, do not account for serial return correlation -this study compares Sharpe ratio results obtained using a technique which accounts for serial return correlation. In addition, this study assess whether the Bias ratio supplements the Sharpe ratio in the evaluation of hedge fund risk and thus in the investment decision-making process. The Bias and Sharpe ratios were estimated on a rolling basis to ascertain whether the Bias ratio does indeed provide useful additional information to investors to that provided solely by the Sharpe ratio.Keywords: Hedge Funds; Bias Ratio; Fraud; Risk Management; Sharpe Ratio INTRODUCTIONnstitutional investors and wealthy individuals have for a long time been interested in hedge funds as alternative investments to traditional asset portfolios, while the public's interest in the hedge fund industry has also increased through spectacular hedge fund activities, such as the collapse of Long Term Capital Management (LTCM) in the late 1990's. Since the early 1990's, hedge funds have become an increasingly popular asset class as global investment rose from US$50bn in 1990 to US$2.2tn in early 2007 (Barclayhedge, 2013). In March 2012, long/short equity funds accounted for the largest portion -23% -of the industry by assets (Citi, 2012). The hedge fund industry posted its sturdiest gains, in terms of asset flows and performance, between 2003 to 2007 where after the financial crisis significantly curtailed growth. However, industry growth reversed, declining to US$1.4tn by April 2009 due to substantial investor redemptions and performance-based declines (Eurekahedge, 2012). In April 2013, total assets under management (AUM) for the hedge fund industry had risen to only US$1.9tn (Eurekahedge, 2013) Source: Barclayhedge (2013) Although most comparisons of hedge fund returns concentrate exclusively on total return values, comparing funds with different expec...

Flagging potential fraudulent investment activity

“…The comparative analysis of FFS's returns to that of the S&P500 index outlined various metrics that can be used to augment a high bias ratio in flagging a fund for potential suspicious activity. These findings confirm warning signals identified by Bollen and Pool (2008) and van Dyk et al (2014).…”

“…Metrics that are governed by subjective thresholds do reduce their strengths across different funds; in addition, the metrics mentioned above do not take into consideration upside potential (van Dyk et al, 2014).…”

“…The bias ratio generates a ratio of positive to negative returns, within a one standard deviation closed interval above zero and a one standard deviation half open interval below zero (van Dyk et al, 2014). It scrutinises the degree of symmetry of observed returns attempting to flag a potential misrepresentation of returns.…”

“…This paper applies the bias ratio to Fairfield Sentry Ltd. (FFS) (the well-known Ponzi scheme administered by Bernie Madoff) and compares the ratio to a proxy for a non-fraudulent fund, the S&P500, as conducted by various researchers (Abdulali et al, 2009;van Dyk et al, 2014). This paper also applies the metric (and others) to several South African hedge funds.…”

Detecting Investment Fraud Using the Bias Ratio

“…The purpose of this research is to extend and augment available research. The bias ratio can help filter suspicious funds that may possibly be manipulating returns and ultimately the NAV, furthermore the bias ratio can be used to identity illiquid assets where they should not be present (van Dyk et al, 2014). By supplementing results obtained from the bias ratio with other statistical measures, early, reliable detection of fraud may be possible, thereby alleviating much of the losses incurred by illegal activities including return manipulation and insider trading.…”