Hedge funds and Private Equity - PES

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Indeed, it may well be that much of the added value of hedge funds which seems to have been
identified in the past (ie. the investment out performance of the early adopters) has now been
competed away by rival firms entering the market. As with many innovations in asset management,
the added value lasts only as long as the general market remains unaware of trends
(previous examples have included small company investments, momentum and value investing
etc). Once the information is disseminated to the rest of the market this value dissipates.
Moreover, there is some concern that the claims of out performance have been inflated because
of survivorship bias within the universe of funds that have been used to measure performance.
For example, investment bank Barclays Capital puts the typical level of overstatement of returns
at 1 – 6 per cent a year, depending on the index 51 .
Analysis produced by Vanguard Investments 52 , which adjusted the annual returns of the Tremont
hedge fund index for the costs identified in Malkiel-Saha’s work (see below), suggests that the
actual returns achieved by hedge funds fall dramatically and seem to have produced returns well
below those achieved by a simple portfolio of 50% bonds and 50% equities (see table below).
Tremont hedge fund index:
returns without Malkiel-Saha
adjustment
Tremont hedge fund index:
returns with Malkiel-Saha
adjustment
50% Dow Jones Wilshire 5000/
50% Lehman Aggregate
Hedge fund return comparison – Average annual returns
1994-2003 1995-1999 2000-2002 2003
11.11 18.16 4.09 15.47
2.32 9.37 -4.66 6.72
9.30 17.41 -2.10 17.93
It is interesting that the adjusted hedge fund index returns are lower than the mixed portfolio over
the whole period and when segmented into bull and bear equity markets.
The key concerns relate to biases that exist in the published indices of hedge fund returns –
these biases can lead to claims about investment performance being overstated.
The main biases are called backfill and selection bias and survivorship bias. Furthermore, there
are additional concerns about the persistence of returns and the attrition rates amongst hedge
funds.
Backfill and selection bias. Hedge funds are often established with seed-capital and will begin
reporting on their results at a later date. But backfill and selection bias can occur because hedge
fund managers are able to ‘fill back’ only the most favourable investment returns into an index.
This can result in returns being overstated.
This effect was demonstrated in a study undertaken by Malkiel and Saha, which examined the
hedge fund returns over the period 1995-2003 53 . Malkiel and Saha used the TASS database (a
51 See Hedge fund returns ‘are vastly overstated’, Timesonline, 28/02/2006
52 Hedge fund index biases , Vanguard Investments, November 2004,
http://www.vanguard.com.au/library/pdf/RL%20Hedge%20Fund%20Biases%20112004.pdf
53 Hedge Funds: Risk and Return, Burton G. Malkiel and Atanu Saha, Financial Analysts Journal, Volume 61, Number 6, 2005,
http://www.cfapubs.org/doi/pdfplus/10.2469/faj.v61.n6.2775