The Major Data Flaw Skewing Hedge Fund Returns

Hedge fund guys must be geniuses, right? I mean, they consistently beat standard market returns. And if they can convince everyone to pay them 1%-2% plus 20% of the profits, they have to show some nice profits for investors.

Well, turns out they may not do as spectacularly as meets the eye. A couple of academic types took a closer look at Hedgie results and found some flaws in the whole reporting structure that leads to some wacky biases. This, via Bloomberg: 

"Their study shows that due to inherent biases in the way hedge-fund databases compile results, the industry's returns have been about half as strong as they appear. The average annualized return for the industry since 1996 goes from 12.6 percent to 6.3 percent when the biases are removed from the data, according to the paper." 

So what are these biases they speak of? 

"The biases stem from the fact that hedge funds voluntarily report results to these databases.  The main reason they cough up the data is for marketing purposes, according to the paper, and funds generally begin contributing their returns once they have results worth bragging about. And since the funds include prior returns when they first enter the database, it leads to a 'backfill bias' or 'instant history bias' that boosts the average returns. (Hat tip to CXO Advisory for spotting the study last week.) 

Since funds can stop reporting to the database at any time -- say, for example, if returns are terrible -- this can cause an 'extinction bias.'  In 2014, they note, the attrition rate rose to 26 percent in the database studied, suggesting that either the number of hedge funds is declining or that fewer hedge funds are choosing to report their returns." 

I don't invest in hedge funds, so this isn't something I've ever looked at or even thought about. But… just wow.

That whole voluntary reporting system is a terrible flaw in the data presentation. I'm not sure the academics have the right number either, as they're forced to fill in the blanks, so to speak. But it's also possible net returns are even worse than meet the eye. 

Now, it doesn't speak to the giant Hedgies that everyone's seeing in print and TV and all. Their returns are their returns -- presuming they're reporting into the system. And since they control the lion's share of the dollars invested, it does suggest that investor returns are pretty close to what we think. Rather, it says that your odds of investing in a smaller fund that actually beats the market are rather small. 

In a sense, it's like analyzing one gigantic trading room. A large majority of traders underperform and ultimately leave the "room" altogether. A small minority do quite well and serve to somewhat skew the impression of the group in general. 

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.