Overstating Returns

Like so many bubbles, the hedge fund bubble is further fueled by bad numbers. The telco/dot.com bubble had accounting gimmicks and stock analysts who provided poor and misleading market information. The hedge fund bubble is fuel by statistical biases in the index the inflate returns:

Fri Feb 11, 2005 07:33 AM ET By Steve Hays

GENEVA, Feb 11 (Reuters) - Hedge fund indexes strongly overstate the industry's investment success and far too much money is being drawn into the funds as a result, with possibly dire consequences in the future, a leading U.S. academic said.

"Between 1998 and 2004 there has been enormous growth in hedge fund assets to about $1 trillion and since they are typically leveraged their buying power is much greater. Hedge funds often account for the lion's share of trading on the New York Stock Exchange," Burton Malkiel, professor of economics at Princeton University said....

Between 1988 and 2003 the Van Global Hedge Fund Index showed compound returns of 15.9 percent, compared with 5.9 percent for the MSCI world equities index and 2.3 percent for the S&P 500 stock index...

But Malkiel said the freewheeling nature of the hedge fund business, with their freedom to choose whether to report performance results and which numbers to publish, compared with the obligatory quarterly reporting of U.S. mutual funds, injected a strong positive bias into industry databases...

Malkiel analysed hedge fund returns for backfill bias between 1994 and 2003 and found that with backfill these averaged 14.29 percent, but without backfill 8.45 percent - a 584 basis points difference in performance.

Another problem with hedge fund data is "survivorship bias" as they have a much lower survival rate before being closed down than mutual funds, meaning indexes tend to reflect the results of successful funds rather than poor-performing dead funds.
Of 604 funds in the TASS hedge fund database in 1996, some 480 had "died" by 2003.

Full article.

Full academic paper.

INTRODUCTION

The hedge fund bubble seem to fit the classic arc of a too many people jumping in to take advantage of the newly perceived benefits of a financial arrangement, saturating the market and thus leading to lower returns.