If not the coffin, we have at least a few nails toward dispelling
the conventional wisdom about survivorship bias in hedge fund
indexes. Our empirical research will demonstrate that hedge
funds more often stop reporting returns following periods
of positive performance, not when they are likely dying off.
What is survivorship bias? Survivorship bias is the distortion
of an index that results from not including certain members
in the average.
If the funds with poor results dissolve, the remaining positive
funds cause the average to overstate the industry average.
This issue has been assessed and quantified numerous times
across many stock and mutual fund indexes. Since some of these
indexes do not include members that have failed, the index
is distorted by the exclusion of negative events.
As mutual funds are registered securities, active funds must
report their results. Funds with good performance continue
to existand as registered securities must report-so
the average always includes positive members. Therefore, the
exclusion of deceased funds skews the average by excluding
those members that had poor results. This creates a bias toward
the results of surviving funds. The resulting overstatement
of performance is known as survivorship bias.
There are several critical elements contributing to survivorship
bias in stock
market indexes. Foremost, the loss of a member is due to below
average performance (thus distorting the average upward);
performers cant and dont stop reporting their
results. Second, reporting is mandatory, thus the index represents
the universe of stock or mutual funds alternatives. We have
no dispute that survivorship bias is alive and well in stock
and mutual fund indexes. However, this issue has also been
expropriated from the public realm and misapplied to the private
world of hedge funds and their indexes.
Both studies indicate that survivorship bias in hedge
may actually cause an understatement of
returns available from hedge fund investing.
NOT FOR HEDGE FUNDS
These distorting elements do not exist in the world of hedge
funds. There may be other issues clouding the picture, but
not survivorship bias. On the other side of the looking glass,
hedge funds cease to report results for two reasons: strong
performance leading to a closing of the fund to
new investors and poor performance closures leading
to new careers for the partners. As well, unlike their publicly
registered counterparts, hedge funds
report voluntarily to one or more industry databases that
compile indexes from those funds that choose to be included.
As a result, hedge fund indexes represent only a general proxy
for the industry rather than a comprehensive measure of it.
Most hedge fund databases generally exist to provide funds
and investors access to each other. Hedge funds that are closed
to new investors have less incentive to provide return information.
As a result, hedge fund indexes are not comprehensive. In
addition, funds that do report may later choose to stop reporting
not only due to poor performance, but also due to strong performance.
This creates a distribution of events that could either overstate
or understate the industry averages and leads to a key question:
arethere more poor performers leaving than strong performers
Why do we even raise this question when, of course, everyone
knows that hedge funds are risky investments and are constantly
blowing-up, only to bury their investors
capital balances. Not so fast.
In two separate studies, we have attempted to quantify the
impact of survivorship bias among hedge fund indexes. Both
studies produced similar results. In the first, we assessed
a series of sixty funds that had ceased to report results
to a recognized hedge fund database. The returns from each
fund were reviewed for their performance during the prior
three months and twelve months. Funds with negative performance
were marked as possible closures, whereas those
with positive results were considered
closings to new investors. We found that almost
two-thirds of funds that ceased to report had positive results
preceding the end of their reporting.
The second and more comprehensive study included 462 hedge
funds that had stopped reporting over a number of years. The
funds were assessed for their performance over the three,
six, and twelve month periods prior to
their last report. For the entire group, the results were
substantially similar to the first study: only about one-third
of funds had poor returns through the point of voluntarily
ceasing to report.
Both studies indicate that survivorship bias in hedge funds
is skewed heavily toward closings (to new investors)
rather than closures (going out of business).
Given the lack of reporting requirements and the potential
for both positive and negative drivers within the hedge fund
industry, survivorship bias may actually cause an understatement
of returns available from hedge fund investing.
Neither of our studies purports to qualify for the financial
journals. Were seeking to provide balance to what has
been a onesided case. The studies represent empirical and
anecdotal evidence that compellingly dispels the tenet of
survivorship bias. Though the results of our studies are not
conclusive, they clearly indicate that further work is needed
to quantify the survivorship bias in hedge fund indexesand
the amount by which their returns actually may be understated.
Mr. Easterling is President of Crestmont Holdings, L.L.C.,
a Dallas-based investment firm that manages a family of hedge
fund of fund portfolios. Crestmonts investment approach
concentrates on niche hedge funds across a broad variety of
styles located primarily in the state of Texas. Crestmont
develops financial market research through its affiliate Crestmont
The Texas Hedge Fund Association (THFA) has been established
to promote the understanding of the hedge fund industry and
dialogue between the regional members of the investment community,
through education and communication. The Association will
encourage the maintenance of industry standards and professionalism
in order to further enhance the growth of the industry. For
more information, refer to www.TexasHFA.com.