Hedge-Fund Benchmarks: Information Content and Biases

We discuss the information content and potential measurement biases in hedge-fund benchmarks. Hedge-fund indexes built from databases of individual hedge funds inherit the measurement biases in the databases. In addition, broad-based indexes mask the diversity of individual hedge-fund return characteristics. Consequently, these indexes provide incomplete information to investors seeking diversification from traditional asset classes through the use of hedge funds. The approach to constructing hedge-fund benchmarks we propose is based on the simple idea that the most direct way to measure hedge-fund performance is to observe the investment experience of hedge-fund investors themselves—the funds of hedge funds (FOFs). In terms of measurement biases, returns of FOFs can deliver a cleaner estimate of the investment experience of hedge-fund investors than the traditional approach. In terms of risk characteristics, indexes of FOFs are more indicative of the demand-side dynamics driven by hedge-fund investors' preferences than are broad-based indexes. Therefore, indexes of FOFs can provide valuable information for assessing the hedge-fund industry's performance. We discuss the information content and potential measurement biases in hedge-fund benchmarks. Hedge-fund indexes built from databases of individual hedge funds inherit the measurement biases of the databases. Survivorship bias occurs when database vendors cannot observe the performance information of hedge funds that have ceased operation. Selection bias occurs because of self-reporting by hedge funds and the inclusion criteria of database vendors. What has been termed “instant history bias” occurs when a database vendor backfills a hedge fund's return when the fund enters the database. Broad-based indexes mask the diversity of individual hedge-fund return and risk characteristics. The characteristics of such indexes are dominated by the “popular bets” being made by hedge-fund managers. Recently, for example, the market environment has led to significant equity content in these indexes. Consequently, they lack information for investors seeking diversification from traditional asset classes through the use of hedge funds. For these investors, properly constructed subindexes of different hedge-fund styles are more helpful. As an alternative to indexes of individual hedge funds, we propose an approach to constructing hedge-fund benchmarks that is based on the simple idea that the most direct way to measure hedge-fund performance is to observe the investment experience of hedge-fund investors themselves—that is, the funds of hedge funds (FOFs). In terms of measurement biases, the data from the performance of FOFs are simpler and cleaner estimates of hedge-fund performance than are indexes that aggregate the performance of individual funds. In terms of risk characteristics, unlike indexes of individual hedge funds, which are designed to capture the supply-side dynamics of the hedge-fund universe, an index of FOFs is indicative of demand-side dynamics. In the absence of a liquid, traded market of hedge funds, there is little reason to assume that equilibrium between the supply of hedge funds and investors' demand is always achieved. Typically, hedge-fund managers react to market opportunities and their perception of investor preferences. Hedge-fund investors' preferences, however, are likely to be influenced by such factors as their overall asset allocation profiles. We argue that an FOF index thus provides additional valuable information for the assessment of the hedge-fund industry's performance.