In context with performance measurement framework, the hedge fund industry have not evolved. This makes it difficult for investors to depend on historical records while allocating their funds.
The performance data provided by the hedge fund databases and indexes have several biases.
Defining Measurement Bias
Measurement Bias generally refers to any systematic error that occurs in the collection of data or information.
How bias in hedge funds affecting fund performance tracking?
Measurement Bias ( Self Selection):
· The inclusion in a hedge fund database is voluntary and the hedge fund managers can choose to include themselves or not to. In general, if a fund has a poor track record it may not want to expose its performance and will decide not to be included in a database.
· This implies the past performance of the fund is back-filled in the index with the addition of new hedge fund to an index,
· For Example, if the hedge fund is 3 years old, its record for the past three years will be added to the index and the index values will be adjusted accordingly. The successful funds are more likely to be added to an index than an unsuccessful one, which creates a bias in the index.
Research says, it has been observed that backfill bias adds about 4% or more to hedge fund returns.
· Survivorship Bias: When unsuccessful funds are removed from the index, the past index values are adjusted to remove the data of the dropped fund. Since a fund is more likely to be dropped from an index on account of poor performance , such actions create bias in the index.
· Studies suggest that backfill bias adds about 3% or more to hedge fund returns.
Likewise even the risk measures of the hedge funds hold biases.
The traditional measures such as standard deviation and VaR will underestimate the risk of losses for the funds. Even the Sharpe ratio is inappropriate for measuring performance.
To conclude, investors should study with due consideration to fundamentals as well as technical aspects of the funds and account for these biases and risks before investing.