Bias Ratio (finance) - Uses and Limitations

Uses and Limitations

Ideally, a Hedge Fund investor would examine the price of each individual underlying asset that comprises a manager’s portfolio. With limited transparency, this ideal falls short in practice, furthermore, even with full transparency, time constraints prohibit the plausibility of this ideal, rendering the Bias Ratio more efficient to highlight problems. The Bias Ratio can be used to differentiate among a universe of funds within a strategy. If a fund has a Bias Ratio above the median level for the strategy, perhaps a closer look at the execution of its pricing policy is warranted; whereas, well below the median might warrant only a cursory inspection.

The Bias Ratio is also useful to detect illiquid assets forensically. The table above offers some useful benchmarks. If a database search for Long/Short Equity managers reveals a fund with a reasonable history and a Bias Ratio greater than 2.5, detailed diligence will no doubt reveal some fixed income or highly illiquid equity investments in the portfolio.

The Bias Ratio gives a strong indication of the presence of a) illiquid assets in a portfolio combined with b) a subjective pricing policy. Most of the valuation-related hedge fund debacles have exhibited high Bias Ratios. However, the converse is not always true. Often managers have legitimate reasons for subjective pricing, including restricted securities, Private Investments in public equities, and deeply distressed securities. Therefore, it would be unwise to use the Bias Ratio as a stand alone due diligence tool. In many cases, the author has found that the subjective policies causing high Bias Ratios also lead to "conservative" pricing that would receive higher grades on a "prudent man" test than would an un-biased policy. Nevertheless, the coincidence of historical blow-ups with high Bias Ratios encourages the diligent investor to use the tool as a warning flag to investigate the implementation of a manager’s pricing policies.