2.
Survivorship Bias
Each year, hundreds of hedge funds go out of business, which means that an analysis based only on active funds excludes those funds who are most likely to have performed poorly. The result is to overstate the gains to hedge fund investors. This bias is sometimes overcome by including the performance of funds that have closed.
3.
Reporting Bias
This bias is a variation on survivorship bias and typically leads to index performance looking better in down markets than it should. The idea is that in a month when a fund has performed poorly it is less likely to report its return, thus understating the loss to the index during the period. The failure of funds to report could be due to outright fund failures as well as reluctance to report poor results.
4.
Backfill Bias
This bias occurs when a hedge fund is added to the index and its historical returns are “backfilled” into the data. This bias is sometimes referred to as “Instant History” bias. Typically, a hedge fund begins reporting its performance to a database after a period of good performance; as such, the historical performance of those funds that backfill will be higher than those who report contemporaneously. Similar to survivorship bias, backfill bias leads to overstated returns and understated risk.
E.
Other Flies in the Ointment 1.
Hedge Funds’ Liquidity Risk is understated
The argument that hedge funds suffer lower drawdowns than stocks during financial crises is disputed by some who point out that this has been true in the past (i.e., in 1998, 2001 and 2008) because governments have stepped in and reintroduced liquidity in the marketplace, thereby saving hedge funds from suffering the full losses that could have come from their illiquid positions. In future crises, governments may be unwilling or unable to follow the same policy, and hedge fund losses may surpass those of stocks and bonds.
2.
Capacity Constraints
Another problem is one of capacity limitations and performance, and whether certain hedge fund strategies can continue to generate superior risk-adjusted returns as investors pour in additional capital. For example, convertible arbitrage funds – which take hedged positions in convertible securities such as convertible bonds or warrants – have seen their returns affected as more managers chase the same opportunity set. A related issue is that many successful hedge funds limit or restrict new investments, making their outperformance a moot point for most investors. A number of liquid alternative funds are also closing their doors to new investors or imposing high minimum investments as a result of capacity constraints.
3.
Grasping at Straws: Can one benefit from the small fund “premium”?
A tremendous amount of ink has been spilt touting the superior returns achieved on average by small and newer hedge funds and mutual funds compared to older and larger funds.12 However, there has not
12
See for example: “The Relation between Hedge Fund Size and Risk.” Haim Mozes and Jason Orchard. 2010. Also, “Small Hedge Fund Firms: Why do they produce better alpha.” Brad Lawson and Leola Ross. PracticeNote. April 23, 2014.
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