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Published aggregate hedge fund returns are grossly inflated and make the asset class seem far more attractive than it really is. This is due to the staggering effect of survivorship and backfill bias.

Hedge fund performance databases rely on self reporting by managers (so even database providers that try to include results from failed funds lack completeness).

Survivorship Bias results from poorly performing or failing managers stopping to report returns.

Backfill Bias results from new managers adding their (attractive) historical track records to the database (successful managers tend to gather interest and succeed in raising investor capital, while mediocre upstarts fade into obscurity).

Let’s consider an extreme example to illustrate the point. Tremont Capital Management is a leading provider of hedge fund data. Thereported inception to date performance for LTCM (03/1994 – 10/1997) is an impressive 32.4% per annum net of fees. LTCM stopped reporting in October 1997, a full year before the fund collapsed in October 1998 having returned -91.8% to investors. The LTCM blow-up is not part of the Tremont database which reported 32.4% instead of the true -27.0% per annum (Swensen, 2009).

Some academic studies have attempted to put a number to the magnitude of these biases.

Ibbotson (2006) looked at 3,500 hedge funds over 10 years and concluded survivorship bias added 2.9% to returns and backfill bias added 4.6% annually. In other words the aggregate error is

7.5% per year, which is a truly massive number in the investment management industry.

Malkiel (2005) observed that out of the 331 funds that reported returns in 1996, more than 75% disappeared by 2004. He estimates survivorship and backfill bias inflated returns by 4.4% and 7.3% per year.

To put that into perspective, investment managers worry about basis point differences in their performance. Seven percent could easily be a typical capital market assumption for the expected long term return of US equities for a year.

Sources:

Roger G. Ibbotson and Peng Chen “The A,B, Cs of Hedge Funds: Alphas, Betas, and Costs,” Yale ICF Working Paper 06-10 (Yale International Centre of Finance, September 2006)

Burton G. Malkiel and Anatu Saha, “Hedge Funds: Risk and Return,” Financial Analysts Journal 61, no. 6 (2005): 82

David Swensen “Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment” (2009)