FINM2003 Study Guide - Final Guide: Mutual Fund, Market Capitalization, Survivorship Bias
Hedge Fund Performance and Survivorship Bias
1. Backfill Bias: hedge funds reports returns if they choose to do so and they may only
do so when their prior performance is good. Data on average is incomplete
2. Survivorship bias: failed funds drop out of the database
Performance and Changing Factor Loadings
- Hedge funds are designed to be opportunistic, if risk is not constant, alphas will be
biased in the standard linear index model
- Can’t assume it is perfect market timing
- Perfect market timing results in a nonlinear characteristic line and hence greater
sensitivity to the bull market
- Funds that write options have greater sensitivity to the market when it is falling than
when it is rising
- Nonlinear characteristic lines suggest many hedge funds are implicit option writers
Fee Structure
- 2% of assets + incentive fee equal to 20% of investment profits
- Incentive fees are effectively call options on the portfolio with
X= (portfolio value) * ( 1 + benchmark return )
- The manager gets the fee if the portfolio value goes up, but losses nothing if it falls
High Water Mark
- if a fund performs poorly, incentive to close it and set up a new one
- the fee structure can give incentives to shut down poorly performing funds
Funds of Fund
- invest in one or more other funds, providing an opportunity to diversify across hedge
funds
- supposed to provide due diligence in screening funds for investment worthiness
- pay an incentive fee to each underlying fund that outperforms its benchmark even if
the aggregate performance is poor
- spread risk across several different funds, but operate with considerable leverage
- if the various hedge funds in which these funds of funds have similar investment
styles, diversification may be illusory
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Document Summary
Hedge fund performance and survivorship bias: backfill bias: hedge funds reports returns if they choose to do so and they may only do so when their prior performance is good. Data on average is incomplete: survivorship bias: failed funds drop out of the database. Hedge funds are designed to be opportunistic, if risk is not constant, alphas will be biased in the standard linear index model. Can"t assume it is perfect market timing. Perfect market timing results in a nonlinear characteristic line and hence greater sensitivity to the bull market. Funds that write options have greater sensitivity to the market when it is falling than when it is rising. Nonlinear characteristic lines suggest many hedge funds are implicit option writers. 2% of assets + incentive fee equal to 20% of investment profits. Incentive fees are effectively call options on the portfolio with. X= (portfolio value) * ( 1 + benchmark return )
