The current issue of The Journal of Finance (October, 2009) has an article by Bollen & Pool titled "Do Hedge Fund Managers Misreport Returns? Evidence from the Pooled Distribution."
It seems that there's "a sharp discontinuity in distribution [of returns] at zero." "The frequency of returns just below zero is significantly lower than expected, whereas the frequency of returns just above zero is significantly higher than expected." Further, "the entire distribution to the left of zero appears deflated relative to the corresponding mass to the right of zero."
Why would this be? There are more than a few reasons. For example, investors don't like to see negative returns, no matter how small they might be. Also, investors typically respond to positive returns by investing more money into their portfolios.
The presence of less liquid assets appears to possibly be the source of the return discontinuity: that is, the question of how these assets are priced. "Managers have more discretion when valuing illiquid securities." Their "results suggest that some managers distort returns when possible," suggesting "the purposeful avoidance of reporting losses."
Oddly (coincidentally?), the disparity disappears around the time of audits, suggesting that some oversight may be needed.
We should find the empirical evidence and the authors analysis troubling. GIPS(r) will require the use of "fair value" pricing effective 1 January 2011, which might help with this. Further suggestions on pricing of less liquid assets might also be needed, if additional evidence surfaces which calls into question the appropriateness of what's taking place. At a minimum, this article raises loads of questions.