The Rich Man's Disease

Ghost Returns
For a while, I ran Morningstar's hedge fund database. A grim task that, as hedge funds delight in gaming database providers. Consider one hedge fund that started up in the early 1990s. "Four months later the fund began reporting to a database, and a year after inception it reported assets under management (AUM) in the top quintile of all funds. In the mid 2000s, the fund experienced a troubled quarter and saw its AUM halve in value. It then ceased reporting AUM figures. The fund's performance recovered, and during the last quarter of 2008 it reported a particularly good double digit return, putting it in the top decile of funds. However, a few months later this high return was revised downward significantly, into a large negative return."

The example and quote come from "Change You Can Believe In? Hedge Fund Data Revisions," a working paper by professors at Oxford and Duke. As private entities, hedge funds can pick and choose when reporting to databases. They often report to some databases and not others; they release some data points and not others; and they appear and disappear from the databases on terms that the hedge funds find to be favorable. Worst of all, and the paper's subject: Hedge funds might not report correct performance.

In the four-year period from 2007 to 2011, the professors found that 49% of hedge funds later revised at least one of the monthly performance figures that they submitted to the database providers. That wouldn't be of particular concern if the revisions were tiny. In some cases they were--only a single basis point. However, 21% of the funds had one or more revisions that were at least a percentage point--a large amount indeed.

The professors found a number of disturbing tendencies with these performance revisions. More of them were down than up. Hedge funds that had at least one performance revision had lower future returns than funds that did not have revisions, with the gap between the two groups being a hefty 3.5 percentage points per annum on a risk-adjusted basis. In addition, funds that had a performance revision were likelier to cease operations and liquidate.

All this suggests that hedge fund databases provide a new data point: Fund has previously revised a performance number. Fortunately, it is not a data point that is necessary for mutual funds. In addition to having much lower expense ratios than hedge funds, mutual funds rarely revise their past performance figures, and when they do it's almost always a tiny adjustment. Receiving bad data is a rich man's disease.

What's Up With Money Funds?
Ever since 2008, when Reserve Primary Fund sparked a panic by breaking the buck, the SEC has threatened to end the fiction that money market funds have fixed, immutable prices of $1.00 per share. Money funds hold very short-term securities, of a very high quality, so they are as close to being riskless as is possible this side of possessing an overnight Treasury. Nonetheless, their portfolios do contain marketable securities that have fluctuating prices, so on occasion a money fund's portfolio might be worth $0.99 or $1.01. The SEC figures that investors are best off realizing and accepting these price moments. Banks, which compete with mutual funds for assets, heartily agree. The mutual fund industry believes otherwise.

And that's where we are. The SEC has been tied in knots trying to get the staffers and commissioners in sync. There's a new version of the proposal now that is something of a compromise, requiring institutional money funds to float their net asset values but not retail funds. What differentiates the two types of funds, and why the one type should be required to float but not the other, remains unclear. This issue doesn't look to be settled anytime soon.

Thinking Flexibly
A surprisingly polite Peter Andersen, manager of Congress All Cap Opportunity , emailed after reading my column from last week about why Morningstar doesn't have a category for all-cap funds. Andersen shared with me his difficulties in communicating his fund's investment approach. Generally, when he talks to consultants and other fund gatekeepers, they point to the Morningstar Style Box and ask, "Where do you fit?"

That's frustrating to hear because, as Don Phillips puts it, Morningstar's style boxes are descriptive rather than prescriptive. They describe where a fund is currently positioned (the style box graphic) and where a fund has been positioned on average over the trailing three years (the category assignment). That's valuable information. The Congress fund, for example, appears as large-cap growth for both the style box and category because in recent years Andersen has gravitated toward big growth companies. At another time, the fund might favor other stocks. The style box is a tool for tracking when such a change occurs.

Per last week's column, I can't see how Morningstar would create an all-cap category based on how funds behave. Compare the Ownership Zone for Andersen's fund with the Ownership Zone of venerable Nicholas Fund (NICSX). One is an all-cap fund, one is not. See much difference?

That said, we might be able to work up a compromise. It seems to me that Morningstar could carry a data point for self-identified all-cap or flexible-cap funds. That data point wouldn't be as precise as a style box or category because it would not be assigned quantitatively. It would instead be the word of the fund company. At least, however, investors seeking such funds would have an easier way to do so. And through the creation of the data point, Morningstar would tacitly acknowledge the existence of such strategies. I have my arguments against the approach--but I might be wrong. There's certainly no reason why people couldn't disagree and wish to use Morningstar information to identify such funds.

So, let's do it. Off to talk to the programmers. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.