A CRITICAL EXAMINATION OF HISTORICAL HEDGE FUND RETURNS
Nolke Posthuma and Pieter Jelle van der Sluis
As discussed by others throughout this volume, though perhaps not in exactly these words, knowledge is power. Investors who understand the way hedge fund data is gathered have insight into the data’s biases and limitations. Better investment decisions are the inevitable result.
Posthuma and van der Sluis implement a new approach for cleaning hedge fund index data affected by the well-known backfill bias in hedge fund returns data. This bias exists because hedge fund managers choose if and when to have their funds’ returns added to common databases.
A combination of this self-selection and liquidation results in hedge fund index returns to appear better than they actually are. Posthuma and van der Sluis show using their methodology that backfill bias may be much greater than previously thought. They find that it is pervasive across hedge fund styles and time periods.
They then use their cleaned data to examine whether they can find persistent patterns in hedge fund returns. If abnormally high returns persist, that is support for the argument that hedge funds (at least some at any rate) do provide excess returns. They divide hedge funds into deciles and examine the decile migration probabilities in consecutive periods.
They find that a fund in the highest (lowest) decile in one month has the greatest chance of remaining in that decile the following month. Interestingly, and somewhat contradictorily, they find that the second most likely return decile for the top (bottom) decile funds in the following month is the lowest (highest) decile. When they assign funds to deciles according to their information ratios (to account for volatility), they obtain similar results.
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ERRATA AND OTHER MATERIAL
- Related research:
- Malkiel, B and Saha, A., 2004, "Hedge Funds: Risk and Return," Working Paper (December).
download paper (1.38Mb)
- Van, G. P., and Song, Z., 2004, "Historical Hedge Fund Returns Fairly Represent Performance," Working Paper (December).
download paper (201Kb)
- Other research by Nolke Posthuma:
- Other research by Pieter Jelle van der Sluis:
- Homepage of Pieter Jelle van der Sluis:
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