We propose an econometrically logical approach that distinguishes intentional from inadvertent smoothing of hedge fund return. Other than the hedge fund return (Y) we introduce an explanatory variable: a market portfolio of hedge fund returns (X). By connecting X and Y, some critical parameters are found to be uniquely related to the two types of return smoothing. Using those parameters, we develop distinct desmoothing algorithms against intentional and inadvertent smoothing. Our empirical results show that although intentional smoothing is partly attributable to hedge fund smoothing, return smoothing is mainly caused by the nature of underlying assets; moreover, intentional smoothing is done more consistently than inadvertent smoothing.

Keywords: intentional smoothing, inadvertent illiquidity smoothing, desmoothing algorithm, latent factor model, single equation error correction model