Indices of fund performance have been constructed such as the Credit Suisse First Boston/ Tremont index and the Van Hedge Fund Index. Index performance results can be found in most major financial publications. These indices routinely show that hedge funds in the aggregate offer superior performance with lower risk than the stock market. However, the issue of bias in return data collection dogs the hedge fund world.
Unlike their heavily scrutinized brethren in the mutual fund industry, these alernative investment managers need not report their returns and only voluntarily report results to these index services. They also have the option to report prior period returns upon joining an index – a practice known as “backfilling”. Needless to say, funds that voluntarily join the indices and report prior results tend to have better performance numbers. Why voluntarily report bad results? Professors Burton Malkiel and Atanu Saha have found that backfilled performance for a given year was 5.8 percentage points higher than the returns of other funds whose results were contemporaneously reported for that year.
Funds also tend to stop reporting results when they run into trouble. After all, no one is forcing them to report and poor performance is bad advertising. The notorious Long Term Capital Management Fund stopped reporting its disastrous results for a full year before its collapse. This is called Survivor Bias.
There is too much positive spin in reported returns of the hedge fund indices. Using data from 1996 to 2003, Drs. Malkiel and Saha found that correcting for backfill and survivor biases reduced the average annual return on these lightly regulated funds, from 13.5 percent to 9.7 percent, which is almost three percentage points less than the return on the Standard & Poor’s 500-stock index for that time period. Hedge funds are not as attractive as advertised.
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