The Great Debate UK

from Breakingviews:

Hedge fund investors need clearer picture

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.