02/04/2014 07:13 pm ET | Updated Apr 06, 2014

The Delicate Craft of Misleading Investors

Proponents of alternative investments (like hedge funds) have a very effective presentation. They claim these investments have low volatility (risk), offer excellent risk-adjusted returns, and don't correlate well with stocks or bonds, thereby providing a "hedge" in troubled times. These proponents demonstrate the accuracy of these claims with compelling statistics, displayed in impressive marketing materials.

Recently, a prospective client said he was considering the purchase of three hedge funds because the metrics were so good. When asked for details, he showed us the marketing materials. My colleague Jared Kizer, director of investment strategy at Buckingham, analyzed these three funds and reported the results in this video blog. Here's what he found:

Claim No. 1: Good Returns With Low Volatility

The funds reported average returns for the period 2003-2012 ranging from 7.6 percent to 9.2 percent. They claimed to have achieved these returns with very low volatility.

It would be appealing to find an investment that yields good returns with relatively little risk. The volatility of these funds was represented to range from 4.1 percent to 6.8 percent annually, which is extremely low and more akin to what you expect from a fixed income portfolio, rather than one exposed to stock market risk.

Upon closer analysis, the volatility was significantly understated. Some of the holdings in these funds were illiquid. They were priced monthly, and the prices attributed to them were more of an estimate than a price reflecting what could be realistically achieved if those securities had to be liquidated. Other pricing data used was stale and did not reflect actual market values.

When the returns were run on a yearly basis, with more accurate prices, the volatility ranged from 8.5 percent to 14.3 percent, which is far less appealing.

Claim No. 2: Excellent Risk-Adjusted Returns

Just because two comparable funds have the same returns doesn't mean they are both taking the same amount of risk. If one fund took more risk than the other, the fund taking less risk would have superior risk-adjusted returns. The Sharpe Ratio calculates the risk-adjusted returns of investments. Higher Sharpe Ratios reflect superior risk-adjusted performance.

The three hedge funds were represented as having Sharpe Ratios ranging from 0.99 to 1.56, which is very impressive. However, when yearly returns were used, the Sharpe Ratios were almost halved, ranging from 0.52 to 0.82.

Claim No. 3: Low Correlation With Stocks and Bonds

Low correlation with stocks and bonds is appealing because it provides greater diversification. The claim is these funds will hold their value and not decline in tandem with the stock and bond markets.

The average correlation of these funds was presented as being only 0.55, which would indicate a relatively low correlation. Once again, using yearly data, the correlation was increased to 0.83.

Summary of Deception

If you accepted the data in the marketing materials at face value, you would have determined an investment in these funds was attractive. The funds were presented as having low volatility, with excellent risk-adjusted returns and low correlation to stocks and bonds.

A more accurate depiction of the data would have shown significantly higher volatility, significantly lower risk-adjusted returns, and a much higher correlation to stocks and bonds.

Kizer advised me that overstating the benefits of these investments is typical in his experience. This is a scary observation. Many investors do not have the resources to do the analysis necessary to determine the validity of the claims made by these funds. Investors might succumb to the temptation to purchase a fund that appears to have appealing characteristics that do not reflect reality.

Some in the securities industry have refined the delicate craft of misleading investors into a fine art.

Dan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth adviser with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His next book, The Smartest Sales Book You'll Ever Read, will be published March 3, 2014.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.