Hedge Fund Performance ‘Exaggerated’ Says Leading Academic

by Carla Johnson, Investors Offshore.com

15 February 2005

Leading economist Burton Malkiel has warned that the figures produced by the various hedge fund indexes may have been overstating the true performance of the hedge fund industry over recent years, contributing to its phenonemal growth.

"Between 1998 and 2004 there has been enormous growth in hedge fund assets to about $1 trillion and since they are typically leveraged their buying power is much greater. Hedge funds often account for the lion's share of trading on the New York Stock Exchange," Malkiel, who is professor of economics at Princeton University, told Institutional Fund Management 2005 conference in Geneva last week.

"Do I have a degree of scepticism about hyped returns? Am I worried too much money is chasing future returns? Yes. Let the buyer beware," added the author of ‘A Random Walk Down Wall Street.’

One of Malkiel’s principal concerns is the lack stringent reporting rules in the hedge fund industry compared to the mutual fund industry. While hedge funds are able to pick and choose the data that they make available to the public, the mutual fund industry is obliged to report results on a quarterly basis.

This, he warned, could allow a positive bias to creep into the performance data of hedge funds and permit practices such as ‘backfilling,’ where managers report returns for favourable months, omitting results for less favourable earlier months.

According to Malkiel, his analysis shows that backfilling between 1994 and 2003 boosted the performance of hedge funds from 8.45% to 14.29%.

Another problem was that hedge fund indexes tend only to reflect the performance of successful funds and not the funds that have performed poorly, a phenomenon known as ‘survivorship bias.’

Pointing to the 604 hedge funds in the TASS index in 1996, Malkiel noted that 480 had fallen by the wayside by 2003.

"There was a 740 basis points difference between live funds and dead funds. If you want to get a feeling of how hedge funds have done, you also need to look at dead funds. From the standpoint of the performance of the industry, you have to look at the whole industry," he observed.

Malkiel also pointed to a wide variation in performance between general hedge fund indexes and their investable indices, and the significant gap in returns produced by the top hedge funds and those at the bottom of the heap.

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