2009 hedge fund results are maybe +13%, not the +19% reported

I found an article on hedge funds in the New York Times (the information appears to have originally come from Reuters) the other day.  It argues that reported hedge fund industry investment results for 2009 are, at +19%–which is not so hot in any event, much higher than the industry as a whole has actually achieved.  +13% is more like the real number.

How so?  Reporting results to index providers is voluntary.  Hedge funds having a bad year simply don’t send in their numbers and are not included in the index.  The evidence?  The large majority of non-reporters drop off the radar screen after a period of poor performance.  Almost no one racks up a history of outperformance and then suddenly disappears.

More research by Malkiel

Anyway, in an (unsuccessful) effort to find the original research article, I turned up some earlier analysis by the same Princeton professor, Burton Malkiel, and a colleague, Atanu Saha of the Analysis Group.  Their paper, which appeared in the Financial Analysts Journal, talks about two factors that bias hedge fund index results upward.  They are:

incubation bias

1.  backfill bias.  The equivalent in the mutual fund world is the “incubator fund,” created using practices common in the Seventies but now banned.  The idea was to create a mutual fund not open to the public, seed it with a small amount of money and run it very aggressively in the hope of achieving a spectacular one-or two-year record.  The fund may well have been given large allocations of “hot” IPOs in an additional attempt to supercharge performance.  If the fund showed off-the-charts returns, it would be offered to outside investors.  If not, it would quietly be closed.

Although now illegal for mutual fund companies, this practice is alive and well in hedge fund land, according to Malkiel and Sana.  Their evidence?  –large numbers of hedge funds with good results that only begin to report results after they’ve been around for over a year.

survivorship bias

2.  survivorship bias. This is the idea that the weak-performing competitors eventually lose their clients and are forced to shut down.  In investing’s version of 1984, their results are then scrubbed from the records–making the “historical” performance of the industry progressively better than what was actually achieved.

Survivorship bias is also present in the mutual fund industry, where unsalable, poor-performing funds are regularly merged with stronger peers in the same fund family.  But during the period they studied, Malkiel and Sana found the upward bias to hedge fund results from this factor was almost 4x the effect on mutual funds.

The researchers also found that a staggering 75%+ of the hedge funds that their database contained had disappeared by the end of the  seven-year period they studied.  No explanation for why this occurred.

the effect of performance fees

I have one thought about this phenomenon–performance fees.  Perhaps the single characteristic all hedge funds have in common is their fee structure: 2% of the assets and 20% of  profits.

Suppose Smith and Jones decide to create a hedge fund, which they call “S&J.”  They raise money and start to operate.  In year 1, they’re down 30%.  If they started with 100, they now have 70.

They won’t be able to collect the 20% of profits until they have some, that is, until they get back over 100, 43% higher than they are now.  That may take two or three years, even in an uptrending market.  What do they do?

One option is to close the fund, return the money and reorganize as “J&S.”  That way they collect performance fees from the outset (assuming they don’t repeat their S&J performance).  Who would fall for this trick, you may ask?  A lot of people, apparently.  Look at the case of John Meriwether, the Salomon Brothers bond trader made famous in Liar’s Poker.

Interestingly enough, the FAJ article drew a critical comment from a hedge fund manager.  I would have expected something along the lines of Mr. Malkiel’s having no actual investment experience or that practitioners of academic finance have about the same relevance–or maybe less–to the real world as deconstructionist literary theorists do to creative writing.

But the critic’s interesting point is that Malkiel doesn’t disclose that he has a conflict of interest.  For about 25 years he was a paid advisor to Vanguard, whose main marketing message has been the superiority of passive over active management.