Discretion, managerial incentives, and market conditions: The misreporting of hedge fund returns

In this study, I document patterns in hedge fund returns that suggest that reporting manipulation is significant and pervasive for hedge funds with discretion in valuing their portfolios of illiquid assets. I show that hedge funds with such discretion report Sharpe ratios that are twice as large as do funds without discretion. I document that manipulation extends beyond the small-loss-to-small-gain kink in the pooled distribution of hedge fund returns to the shoulders and tails of the distribution. I also find that contractual incentives are associated with a larger likelihood of reporting small gains and less extreme returns. Finally, I show that funds with the most discretion report monthly returns that are on average 0.8% higher than funds without discretion. During market downturns, the difference in reported returns between funds with and without discretion increases to 1.3%. These findings bear on the current debates regarding hedge fund regulation, standard-setting for fair-value accounting, and the role of information during market crises.