A Suggestion for Remedying the Overstated Performance of Non-Investable Hedge Fund Indices

Survivorship bias, which results from the ex post exclusion of unsuccessful funds from databases, is clearly one of the greatest causes of grossly overstated performance. Considering the returns of surviving funds alone leads to a strong upward bias, according to recent studies (up to 442 basis points, as demonstrated by Malkiel and Saha [2005]). In the same vein, backfill bias or instant history bias, which occurs when the historical performance of a successful fund is suddenly and retroactively added (backfilled) into the database, also distorts the performance of the hedge fund industry (up to 435 basis points, as shown by Posthuma and van der Sluis [2004]). These biases are not negligible and tend primarily to inflate the returns posted by non-investable hedge fund indices; hence the recent development of investable hedge fund indices that can help investors mitigate the effects, which are never done away with entirely, of these biases.