Hedge funds and Private Equity - PES

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These data notwithstanding, several commentators have criticised the claims made for hedge
funds. Historically hedge funds have been a niche sector focused on specialised investment
strategies that worked reasonably for a given limited amount of invested capital. The current
growth of their AUM – sparked by low interest rates – could put at risk in the future ability to
provide investors with the high financial returns promised in their marketing.
Other commentators argue that the performance of hedge funds is overestimated already. For
example, the investment bank Barclays Capital put the typical level of overstatement of returns
at 1 – 6 per cent a year, depending on the index 14 . A recent study by the renowned Princeton
professor Berton Malkiel and Atanu Saha reached a similar conclusion 15 . The study identifies a
number of biases that exist in the published indices of hedge fund returns, biases that lead claims
about investment performance to be overstated. Analysis produced by Vanguard Investments,
which adjusted the annual returns of the Tremont HF index for the biases identified in Malkiel
and Saha’s study, suggests that hedge funds produced returns well below those achieved by a
simple portfolio of 50% bonds and 50% equities over the entire period, as well as when
segmented into bull (1995-1999) and bear (2000-2002) equity markets 16 .
Tremont HF index: returns
without Malkiel-Saha adjustment
Tremont HF index: returns
with Malkiel-Saha adjustment
50% Dow Jones Wilshire 5000/
50% Lehman Aggregate
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
What reasons may there be for such an overstatement of hedge fund performance? According
to Malkiel and Saha the key reasons relate to biases that they call backfill, selection and survivorship
bias. Furthermore, there are additional reasons related to the lack of persistence of returns
and the relatively high attrition rates amongst hedge funds. Below we describe these reasons in
greater detail.
– Backfill and selection bias: hedge funds are often established with seed-capital and will
begin reporting on their results at a later date. Yet, 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. According to the study by Malkiel and Saha
backfilled returns significantly bias the returns upwards. The arithmetic mean of the backfilled
returns over the period 1994-2003 was 11.69%, while the mean for the contemporaneously
reported returns was 5.95% – a difference of 5.74%.
– Survivorship bias can occur because the published indices may not include the returns from
hedge funds no longer in existence (known as ‘dead’ funds), or funds that exist but no longer
report their results (‘defunct’ funds). Malkiel and Saha examined the effect of this survivorship
14 See HF returns ‘are vastly overstated’, Timesonline, 28/02/2006
15 Malkiel, B. G./Saha, A. (2005): HFs: Risk and Return, Financial Analysts Journal, Volume 61, Number 6, CFA Institute. The study draws
on the TASS database.
16 HF index biases, Vanguard Investments, November 2004, http://www.vanguard.com.au/library/pdf/RL%20Hedge%20Fund%20Biases%
20112004.pdf