The reason for the predictability of mutual fund returns is based on the industry standard to fix the net asset value (NAV) of a fund only once every day at 4 pm eastern time. The fund evaluates its portfolio positions with the last available market price, which may have been observed long before 4 pm when dealing with illiquid positions or non-US exchanges.
There are a number of hedge funds that specialize in exploiting this time lag advantage also called "market timing". In order to restrict or at least limit the use of stale prices, which is harmful for long-term investors, the Securities and Exchange Commission (SEC) executes pressure on the mutual fund industry to calculate their NAV via "fair prices", or to relate their fees to the holding period of fund investors—short-term investment, higher fees.
Hedge funds as well as private equity funds invest in illiquid and irregularly priced securities, which contribute only via estimated values and not as marked-to-market positions to fund performance.
An investigation of the returns has shown that the corresponding volatility, the correlation with traditional asset classes, the autocorrelation, and therefore the risk of the investment are positively distorted. This also influences the shape of the efficient border of a risk/return optimized portfolio.
Neutralizing the stale pricing ef ect results in a substantial increase in risk connected with alternative assets; however, this does not harm the importance of hedge funds and private equity concerning their diversification effect on traditional asset classes. Only the respective weighting of the portfolio constituents is shifted toward risk minimization.