Blogs & Comment

A hedge fund blows up

Alfred and his family came over for dinner during the holidays. While I was in the kitchen getting tea and dessert ready, he came in to talk about the stock market and confide that a hedge fund he had invested in was closing down after a precipitous drop.
Now I know what they mean by survivorship bias, he said with a laugh.
Ah yes, survivorship bias, I replied as I plugged the kettle in to make tea. Thats why published performance figures for hedge funds can be misleading. Many of the poorly performing funds will have disappeared and their performance left out of the calculations. Several academic studies have made this claim.
I was thinking about research papers such as Hedge Funds: Risks and Returns, published in 2005 by Burton Malkiel and Atanu Saha. It found that survivorship bias and backfilling (i.e. including returns earned before a fund opened to the public) inflated returns. Between 1995 and 2005, the average annual performance ofsurviving hedge funds was 13.7% but when non-surviving and backfilling funds were included, the average return was a mutual-fund-like 9.3%.
Yes. Anyway, Ive had enough, Alfred continued. The hedge fund is reopening under a new name but Im not going to roll my money into it.
Maybe thats the way to go, I responded as the tea leaves went into the pot. Perhaps your fund is playing the hedge fund game where the managers use one of those strategies that outperform the market six years out of seven but blows-up in the seventh.
I was thinking about the paper, The Hedge Fund Game, written by professors at Oxford University and University of Pennsylvania. Their thesis is that the incentive structure and opaqueness of the industry allows persons to set up hedge funds based on strategies that look good for a few years but are doomed to deliver catastrophic losses at some point. But by the time the blow-up occurs, the managers will have personally taken in several million dollars from the 2% annual fee and 20% cut of gains. Then they simply close down or reopen under a different name.