Research on hedge fund performance derives from voluntary reports by hedge funds to commercial databases. This environment encourages: (1) backfill bias (non-reporting funds doing well are most likely to begin reporting, including historical data that arguably involves some good luck); and, (2) delisting bias (reporting funds doing poorly, arguably due in part to poor strategies, are most likely to stop reporting). Also, young databases tend to have survivorship bias because they have not accumulated much data on “dead” funds. How material is the delisting bias? In their August 2013 paper entitled “The Delisting Bias in Hedge Fund Databases”, Philippe Jorion and Christopher Schwarz compare information across three commercial hedge fund databases to estimate delisting bias. Their estimating process exploits the fact that hedge funds often do not terminate reporting to all three databases at the same time. Using matched monthly hedge fund return data across Tremont Advisory Shareholders Services, the Center for International Securities and Derivatives Markets, and Hedge Fund Research databases during 1994 through 2008 (9,970 funds), they find that:
- On average, about 12% of hedge funds stop reporting (delist) each year, but some funds considered dead in one database continue living in another. The average annualized return of these “partly dead” funds is about -3.5%.
- Averaged over all funds, delisting bias is in the range of 0.35% to 1% per year. This bias:
- Persists through the entire sample period, but is highest in years with elevated fund mortality rates (1998, 1999, 2001 and 2008).
- Concentrates in small funds, which are more likely to delist.
- When added to estimated fees for funds of hedge funds, the delisting bias largely explains their average 2.7%-2.8% annual underperformance relative to direct hedge funds.
- Investors should reduce hedge fund indexes (generally equally weighted) by about 0.5% per year to account for delisting bias.
In summary, evidence suggests that hedge fund indexes overstate annual industry performance by about 0.5% due to hedge funds that cease voluntary reporting to commercial databases.
In general, investors should probably assume that voluntarily reported investment performance is materially biased.
Cautions regarding findings include:
- The sample period is not long for annualized findings.
- The upper bound estimate of delisting bias is crude.
