Hedge Fund Index Performance ‘Exaggerated’, Claims Academic

by Phillip Morton, Investors Offshore.com

09 November 2004

Eminent economics professor Burton Malkiel, author of ‘Random Walk Down Wall Street,’ has alleged in a new working paper that hedge fund index returns do not always tell the whole story of hedge fund performance, and are often exaggerated and distorted by statistical biases.

“We conclude that hedge funds are far riskier and provide much lower returns than commonly supposed,” claims Malkiel, professor of economics at Princeton University in a paper co-written by Atanu Saha, managing principal of a New York-based business consultant and recently submitted to the Journal of Finance for peer review, according to Bloomberg News.

One of the major findings of the study is the practice known as “backfill bias.”

“Managers will often establish a hedge fund with seed capital and begin reporting their results at some later date and only if the initial results are favourable,” the study observed, adding:

“Moreover, the most favourable of the early results are 'backfilled' in the (hedge fund) database along with reports of contemporaneous results.”

Malkiel and Saha found that on average, the ‘backfilled’ returns were 5% higher than the contemporaneously reported returns.

The study also argued that hedge fund index returns may be skewed because funds that have failed and been liquidated are not included in the data. To illustrate the impact that ‘survivorship’ may have on returns, it was noted that only 25% of the hedge funds that reported contemporaneous data in 1996 were still in existence in 2004, whilst on average 10% of all funds fail each year.

In response to the findings, Barry Colvin, president and chief investment officer at hedge fund group Tremont Capital, told Bloomberg “I don't know what database doesn't have survivorship bias in it.”

“There's a wealth of information out there. If you're happy with the numbers, that's all the proof you need,” he countered.

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