Thursday, October 3, 2013

2/3 of hedge funds are dead.

From the FT via Finance at Tepper  - two thirds of hedge funds that are reported in major data sets are dead - they are no longer in existence.  

How can this be?

Simple - hedge funds are started all the time.  If they get off to a good start and make money they are kept open.  But if they don't do well, they are closed down and a new fund is started.   Basically, in the hedge fund industry you get unlimited do-overs as long as you can find money to start funds.

Finance researchers know of this issue which is why they take special care to control for this "selection bias" when they compute returns.   Just looking at the returns of hedge funds in a given year is horribly misleading as these returns are just those of the funds that survived.

A similar thing happens in the mutual fund industry -  mutual fund companies start many funds - and hope that some fraction of the funds will do well.   The badly performing funds get dumped in target date funds which are then sold to unsophisticated individuals.  That's why target date funds are like hotdogs - they are full of the nasty stuff that can't be sold on its own.