The popularity of the endowment model among advisors has been driven by the belief that hedge funds have produced positive risk-adjusted returns.  But the basis for that notion has been statistics gleaned from hedge fund databases, and new research shows returns from those databases are even more upwardly biased than previously thought; the supposed alpha never really existed.

For years, hedge fund databases have contained only data selectively and voluntarily reported by certain funds. Those who research and compile these data have trumped up feeble explanations of why this does not bias the databases, though it clearly does. The uncritical financial media have robotically reported the database statistics as if they were facts.

Now, at last, someone has constructed a database that does not have this self-selection bias, and – surprise, surprise – it reveals that hedge funds on average perform no better than mutual funds. Perhaps worse.

Registered funds-of-funds

In a study titled, “Out of the dark: Hedge fund reporting biases and commercial databases,” Adam L. Aiken of Quinnipiac University, Christopher P. Clifford of the University of Kentucky, and Jesse Ellis of the University of Alabama assessed the performance of hedge funds using a unique data source that is untainted by the self-selection bias afflicting other hedge fund databases.

Registered funds of hedge funds are funds-of-funds that register with the U.S. Securities and Exchange Commission (SEC) under the Securities Act of 1933 and the Investment Company Act of 1940. Registration allows a fund-of-funds to escape certain constraints. For example, while managers of unregistered funds are not allowed to publicly market their funds, registered funds-of-funds can advertise the same way mutual funds do. Furthermore, managers of registered funds-of-funds can give their investors the comfort of knowing that they are more transparent than unregistered funds, reducing the possibility of fraud.

Registration does impose a reporting burden on the funds-of-funds. They must report each quarter their holdings and the cost and market value of each holding. These reported data make it possible to calculate quarterly returns on each of the hedge funds held by the registered funds-of-funds.

By exploiting these data, Aiken, Clifford and Ellis captured more than 10,000 quarterly returns for 1,445 hedge funds over the period 2004-2009. They found that about half of the fund-quarters are also in at least one of the commercial databases – Lipper TASS, Hedge Fund Research, BarclayHedge, Morningstar, or Eureka Hedge. Hence, it is possible to compare a large sample of hedge funds that report to a hedge fund database with a large sample of funds that do not report their data.