Bias Ratio (finance)

Bias Ratio (finance)

The bias ratio is an indicator used in finance to analyze the returns of investment portfolios, and in performing due diligence.

The bias ratio is a concrete metric that detects valuation bias or deliberate price manipulation of portfolio assets by a manager of a hedge fund, mutual fund or similar investment vehicle, without requiring disclosure (transparency) of the actual holdings. This metric measures abnormalities in the distribution of returns that indicate the presence of bias in subjective pricing. The formulation of the Bias Ratio stems from an insight into the behavior of asset managers as they address the expectations of investors with the valuation of assets that determine their performance.

The bias ratio measures how far the returns from an investment portfolio - e.g. one managed by a hedge fund - are from an unbiased distribution. Thus the bias ratio of a pure equity index will usually be close to 1. However, if a fund smooths its returns using subjective pricing of illiquid assets the bias ratio will be higher. As such, it can help identify the presence of illiquid securities where they are not expected.

The bias ratio was first defined by Adil Abdulali, a risk manager at the investment firm Protégé Partners. The Concepts behind the Bias Ratio were formulated between 2001 and 2003 and privately used to screen money managers. The first public discussions on the subject took place in 2004 at New York University's Courant Institute and in 2006 at Columbia University. In 2006, the Bias Ratio was published in a letter to Investors and made available to the public by Riskdata, a risk management solution provider, that included it in its standard suite of analytics.

The Bias Ratio has since been used by a number of Risk Management professionals to spot suspicious funds that subsequently turned out to be frauds. The most spectacular example of this was reported in the Financial Times on 22 January 2009 titled "Bias ratio seen to unmask Madoff"!