Unobserved Performance of Hedge Funds

We investigate hedge funds’ unobserved performance (UP), measured as the risk-adjusted return difference between a fund firm’s reported return and the hypothetical portfolio return derived from its long equity holdings disclosed on a quarterly basis. We find that high UP is (i) positively associated with measures of managerial incentives, discretion, and skill, and (ii) driven by a fund firm’s intraquarter trading in equity positions, derivatives usage, short selling, and confidential holdings. Fund firms with high UP outperform fund firms with low UP by more than 6% p.a. after accounting for typical hedge fund risk factors and fund characteristics.