Portfolio Design: A Modern Approach to Asset Allocation

HEDGE FUND BIASES

Because of the way that hedge fund returns are reported, biases inevitably develop that undermine the performance results reported by the investment industry. This section will describe the major biases and then will attempt to measure how large they are.

There are two major biases affecting hedge fund returns. One bias plagues all asset return data—survivorship bias—although usually it’s relatively easy to correct for it if there is a full universe of data available. The other bias—backfill bias—is peculiar to hedge funds. We will begin by describing backfill bias because it affects data sets from the very beginning.

1. Backfill bias. This is the bias that arises when hedge funds first begin reporting to a database. If a hedge fund has been operating for a few years prior to its first reporting, it’s natural for the managers to offer all of their return data including returns that occurred before database reporting began. Thus the database backfills the return data for that fund. The bias is important in the hedge fund industry because many hedge funds are incubated in their early stages. Families and friends of the manager may be the only investors in the fund at start-up. Or the manager may choose not to report returns at first because the fund is too small. Or the manager may want to see how the fund performs before providing data to an outside consultant. In some cases, hedge fund managers may start multiple funds at the same time and then see which funds ...