An academic explanation for the disparity in hedge fund index returns

So hedge fund indices are all over the board.  But why?

Displaying perfect timing, French business school and hedge fund research hot-bed Edhec just released the presentations and back-ground reports from its recent conference in London – including a July ’07 paper entitled “Revisiting the Limits of Hedge Fund Indices: A Comparative Approach“.  Says the paper:

“One of the reasons for this lack of homogeneity in hedge fund index return data is that none of these existing indices is fully representative. In other words, this is a sampling problem: a number of funds that should be part of an index are not included in the index. Because of the lack of regulation on hedge fund performance disclosure, existing databases cover only a relatively small fraction of the hedge fund population. It is likely that only slightly more than half of existing hedge funds choose to self-report their performance to one of the major hedge fund databases.”

Regular readers may remember this illustration from the London Business School which makes the same point graphically (see related posting):

Continues the Edhec report: 

“In addition, hedge fund indices are built from databases of individual fund returns, and therefore inherit their shortcomings in terms of scope and quality of data, which vary significantly among various data vendors…a fund’s participation in a database is voluntary, which poses a real problem in terms of the reliability of the data published…(This) also poses a problem in terms of the reliability of data and exposes investors, in particular, to a risk of a change in the manager’s management style…depending on the date at which the database began, the quality of past information will vary (notably for funds that ceased their activity before the database began). This affects the performance of the index to a greater or lesser degree, depending on the number of funds that stop communicating their results each year (referred to as the attrition rate)”

The report goes into a lot of detail, but suffices to say, hedge fund indices should be taken as illustrative only.

There’s a lot more slideware and background papers here at the Edhec event’s website.  Problem is, unless you were there a lot of it doesn’t make much sense.  Key lesson: make the trip to London next time.  

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