Why hedge funds do well in December

Feeling battered by poor returns from your hedge fund managers this year?

Well, returns are likely to improve significantly next month, or at least seem like they have improved.

Some interesting new research from three academics in the US and UK indicates that hedge fund managers actually manage their reported returns to get a spike at year end in December.

The researchers - Vikas Agarwal from Georgia State University, Naveen Daniel from Drexel University and Narayan Naik from London Business School - show that December returns are significantly higher than those of other months even after controlling for the hedge funds’ risk exposure and factor risk premiums in December.

“More importantly, we find that this December spike is higher for funds with greater incentives and greater opportunities to inflate returns,” they say in a yet-to-be-published paper.

“These results suggest that hedge funds manage their returns upwards in an opportunistic fashion in order to earn higher fees…We provide evidence that funds inflate December returns by under-reporting returns earlier in the year and/or borrowing from January returns in the following year.”

The researchers found that the December residual spike was 36 basis points and that the cross-sectional variation was positively related to the incentives offered the manager to maximise fees and the opportunities available to engage in “return inflation”.

They point out that the research has implications for regulators concerned about accurate securities valuations in hedge funds and investors who miss out on their rightful returns depending on the timing of their entry into or exit from the fund.