In addition to survivorship bias, other difficulties exist in tracking the performance of hedge funds on the whole. Hedge fund managers are not required to report their performance. Managers may choose "opportunistically" when to report performance-a bias that is driven at times by lack of performance. Conversely, hedge fund managers may choose to stop reporting performance because their funds have closed, and they are no longer looking to attract new assets. This self-selection bias can further affect the net performance of hedge fund indexes.
Yet another bias affecting the validity of hedge fund performance is the index flaw known as "instant history" bias. Many hedge funds are incubated before assets are accepted from outside sources. In some occasions, the incubator of the hedge fund will decide not to open the fund to outside investors due to poor performance or lack of interest. This leaves the remaining funds that come out of incubation with an instant history bias. Simply put, in these cases only the performance of successful funds is reported, thereby creating a bias towards funds with decent performance.
In assessing whether to invest in a specific hedge fund, it is important to understand that these biases impact only hedge fund indexes. Indexes should be used only as a general guideline to gauge hedge fund performance, unless investors are investing directly into a hedge fund index. Similar to analysis of traditional managers, a thorough due diligence process should help identify those managers worthy of a recommendation to clients. Hedge fund indexes, although flawed, are used in this paper for lack of a better source for illustrating how hedge funds perform and benefit a diversified portfolio. However, when actually analyzing individual hedge funds, performance should be assessed on a case-by-case basis.
Conclusion
For certain investors, hedge funds offer a compelling complement to MPT and should be implemented when devising investment portfolios. Hedge funds have consistently provided noncorrelated returns, may significantly reduce portfolio volatility and may provide significantly better returns over time, primarily by outperforming equity markets during down periods.
Gene Swanzey is vice president of FBR Investment Management Inc., an SEC registered investment advisor subsidiary of Friedman, Billings, Ramsey Group Inc. (NYSE: FBR), a publicly traded financial services company. Swanzey can be reached at (703) 469-1293 or [email protected].