Overview: When investors hear about hedge fund returns, they should be cautious about the information they are getting. In many cases, the returns they are seeing may be a little biased. The following discusses some of the common problems with hedge fund data.

There are many problems when looking at hedge fund data. Academics try to account for these problems in their studies, but investors are left to either take hedge fund returns data at face value or make arbitrary adjustments to the numbers. These data issues overstate returns and understate risk, which can make hedge funds appear attractive. Here are a few of the biases that impact hedge fund data:

Survivorship Bias — Survivorship bias is the tendency for failed funds to be excluded from the data. A study appearing in the Journal of Asset Management found that this bias was so great that it added 4.4 percent per year to reported hedge fund returns.¹

 

Backfill or Instant History Bias — This bias occurs when hedge funds are added to an index and their past performance is “backfilled” into the index. A study by Princeton professor Burton Malkiel that appeared in the Financial Analysts Journal found that backfill bias overstated hedge fund returns by 5 percent per year.²

 

Self-Selection Bias — This bias results from some funds choosing not to report their returns. It is especially interesting because it can work both ways. If funds perform poorly, they may stop or never start reporting results for obvious reasons. On the other hand, well-performing funds may not report results to an index because they do not need the marketing benefits from being members of the index. These funds will attract investors because of their reputation. The impact of this bias is nearly impossible to quantify because hedge funds are subject to little regulation in terms of reporting returns.

 

Liquidation Bias — Frequently, hedge fund managers will either go out of business or shut down an unsuccessful hedge fund. When this happens, the managers will stop reporting returns prior to actually closing the fund. Closing the fund could take months, and these months can be lost in the hedge fund databases. This is another case where it is nearly impossible to quantify the impact of the bias.

 

In conclusion, it is important to note that because all hedge fund indexes and databases suffer from these problems (to varying degrees), these problems cannot be diversified away by combining multiple indexes. When investors read articles or papers touting the performance of hedge funds as an asset class, they should keep these biases in mind.