Hedge fund investors need clearer picture

January 6, 2010

Only foolhardy parents would allow their children to reveal just the grades on their report cards they were happy with. Yet hedge funds are given this luxury in reporting their performance to compilers of sector-wide performance indices. The result is that while a single fund’s track record is clear enough, hedge fund index returns still flatter the average fund. Investors would be smart to call for a clean-up.

Taken at face value, historic index figures suggest that even a very average hedgie can easily beat the stock market while taking less risk. Since 1990, a weighted index of hedge funds has returned around 12 percent annually — about 4 percentage points more than the S&P 500 — with just half the volatility, according to Hedge Fund Research.

On closer inspection these claims look suspect. Research published in late 2007 by Princeton’s Burton Malkiel showed that many hedge funds simply stop reporting results when they become embarrassing. For funds that ceased reporting, the average monthly return in the six months before they did so was negative 0.56 percent, against an average monthly return of plus 0.65 percent during their reporting lives.

The implication is that failing funds drop off the radar before they report even bigger losses or close altogether, thereby excluding their poor performance from indices. Cases in which a fund’s returns soar prior to radio silence are much harder to find, research suggests. Based on Mr. Malkiel’s studies and other academic work, hedge fund investors should probably knock as much as 4 percentage points off reported industry-wide returns to get a more realistic comparison — and that makes hedge fund managers look much less special.

This problem of voluntary reporting is in addition to what’s known as survivorship bias, by which poorly performing funds that close down drop out of the index. Of course, index providers have tried to work out how to deal with flaws of this kind in indexing.

It’s also not unique to hedge funds — aggregate figures for mutual funds and other assets can be similarly distorted. But the high mortality rates for hedge funds, which tend to die at roughly twice the rate of mutual funds on average, makes the issue particularly acute. And mutual funds are obliged by regulators to report returns, making relevant indices less prone to distortion than for hedge funds that report voluntarily.

For another piece of evidence, consider HFR’s investible Global Hedge Fund Index. Because this tracks real money invested in hedge funds, reporting vagaries ought to be less of an issue. Sure enough, the index has underperformed HFR’s broader theoretical benchmark in each of the last seven years, typically by a meaningful margin. In 2009, a recovery year for hedge funds, the investible index rose around 13 percent year compared with 19 percent for HFR’s voluntarily-reported index.

To be fair, hedge funds for the most part don’t, individually, use indices to attract investors – they use their own returns, which are clear-cut indicators of performance. But in more general terms, the industry uses index data to burnish its image as a whole in the eyes of investors and, to some extent, to deflect calls for regulation.

One example: In congressional testimony in November 2008, James Simons, the founder of Renaissance Technologies, used index figures to back up his claim that most hedge fund managers “turn out to be relatively cautious.” That may be right, but investors and regulators ought themselves to be cautious about placing too much reliance on the data behind that statement.

What could index providers or fund managers do to improve the situation? Respectively insisting and acknowledging that funds included in indices should report their performance from the day they open their doors until the day they close would be one thing. Allowing for a modest delay would remove the excuse that revealing results would risk giving away hedge funds’ precious investment secrets.

Investors could do their part in pushing for better data, too – and maybe newly hands-on regulators have a role to play as well. Hedge funds still have a strong argument that they offer useful alternative strategies for investors and liquidity for the financial system. But they should be grown-up about making it: They needn’t rest the case on flawed statistics.


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How much of a clearer picture, a little or a lot? X-rays of contemporary hedge funds might reveal how many of them are a little bit pregnant with Rosemary’s Baby. Strip away their leaden boilerplate of plausible deniability at your peril.

I doubt most hedge fund investors really want to know what their investments are doing to the world and, in the end, to themselves. It’s just something some people don’t mind doing as long as they don’t know too much.

Why spoil it for them with knowledge?

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