Emerging hedge fund managers are getting more attention from institutional investors because they tend to produce better returns than larger, more established funds, but industry insiders disagree about the extent of the outperformance.
Hedge fund investment consultants and early-stage hedge fund-of-funds managers are critical of industry-produced and academic analyses that don't correct for survivorship and backfill biases found in the various public databases that aggregate self-reported hedge fund returns. They say statistical studies that include these two biases produce artificially high returns for both small/young and large funds.
One of the industry's most widely read performance comparison studies, by PerTrac Financial Solutions LLC, showed small hedge funds managing less than $100 million each produced 360 basis points of annualized outperformance over large funds each managing more than $500 million over the 15-year period ended Dec. 31.
Young hedge funds in business less than two years returned an annualized 526 basis points more than those in operation for more than four years over the same time period, PerTrac researchers found.
But PerTrac's most recent analysis of 7,157 hedge funds created from the merger of five hedge fund databases did not correct for survivorship and backfill biases, and the returns calculated by the study are overstated, consultants said.
Survivorship bias is introduced into a hedge fund database when a fund closes and its track record is removed, resulting in improved returns overall because the database tracks only successful funds. Backfill bias occurs when a hedge fund includes past performance in its first report to a database.
The combination of survivorship and backfill biases accounted for 718 basis points of the 14.88% annualized performance of 6,169 hedge funds from within the TASS database for the 15 years ended December 2009 that were analyzed by Roger G. Ibbotson, Peng Chen and Kevin X. Zhu.
Lisa Corvese, managing director of global business strategy of New York-based PerTrac, a financial software developer, said instant-history and survivorship biases are “inherent in all publicly available hedge fund databases” because there is no standardization of the data requested of hedge fund managers by database vendors.
“People rant about these biases all the time, but no one has a good, easy solution for getting rid of them,” Ms. Corvese said.
The good news for institutional investors is the small cadre of institutional-quality emerging hedge funds run by experienced portfolio managers has outperformed larger funds over time, just by a smaller percentage than industrywide statistics suggest.