Hedge Fund Return Timing Bias

It's well-known that there's a backfill and survivorship bias to many Hedge Fund indices. As most indices promote their product, this is understandible. Yet just as with the equity risk premium, the hedge fund bias usually neglects the adverse timing bias: that market inflows and outflows make the raw time series returns overestimate the return to an average investor. Thus, many funds with $100MM in assets have great return their first year, of say 50%, and then get on the cover of a big magazine, get $1B, and lose %20. Is the return on such a fund the average--geometric or arithmetic--of the 50% and -20% return, or should it weight the 20% loss more, reflecting the performance of the average investor in that fund?

I remember in 2004 or so when convertible bonds got rocked, convertible bond indices simply disappeared, merged into other indices within broader Fixed Income categories. But then, after a strong rebound, they returned as if nothing happened.

Ilia Dichev has a new paper out (with Gwen Yu) in the JFE documenting this bias is around 3-7% for hedge funds, just as he found this bias was around 3% for equity indices:

We use dollar-weighted returns (a form of IRR) to assess the properties of actual investor returns on hedge funds and compare them to buy-and-hold fund returns. Our main finding is that annualized dollar-weighted returns are on the magnitude of 3 to 7 percent lower than corresponding buy-and-hold fund returns. Using factor models of risk and the estimated dollar-weighted performance gap, we find that the real alpha of hedge fund investors is close to zero. In absolute terms, dollar-weighted returns are reliably lower than the return on the S&P 500 index, and are only marginally higher than the risk-free rate as of the end of 2008. The combined impression from these results is that the return experience of hedge fund investors is much worse than previously thought.

Antti Ilmanen estimates a 3-5% survivorship bias, and a 1-3% backfill bias in Hedge Fund indices, so be sure to add to those. Here's something simple and valuable the new Consumer Financial Protection Bureau can do: monitor and disseminate accurate asset class performance data, eliminating the bias present in most indices that tend to inflate all of them.