[16264]
July 3, 2003
TO: SALES DESK MANAGERS ROUNDTABLE No. 6-03
SALES FORCE MARKETING COMMITTEE No. 10-03
DIRECT MARKETING COMMITTEE No. 8-03
RE: INSTITUTE MEMORANDUM REGARDING SHORTCOMINGS IN HEDGE FUND
PERFORMANCE MEASURES
The Securities and Exchange Commission recently solicited comments with respect to its
review of the hedge fund industry. 1 In response, the Institute filed the attached memorandum
prepared by two of the Institute’s senior economists addressing a topic discussed at the SEC’s
recent roundtable on hedge funds: the reported performance of hedge funds compared to
diversified equity mutual funds and the possibility of making private, unregulated hedge funds
publicly available to average investors. The memorandum is summarized below.
The memorandum points out that many recent reports about hedge fund performance
statistics substantially overstate hedge funds’ actual performance. In particular, many
discussions about average hedge fund returns are based on hedge fund indexes with significant
biases. These indexes exhibit upward performance biases while exhibiting downward biases
with respect to risk measurements.
The memorandum explains that hedge fund indexes used to compute total return and
other performance statistics contain biases because these indexes are not representative of the
universe of hedge funds. In fact, no universal database exists that contains the records of all
hedge funds, both those currently operating and those that have ceased operating. Instead of a
universal database, several commercial databases are available that contain subsets of the
universe of hedge funds. It is quite likely that these database indexes overstate the performance
of hedge funds generally because they do not contain a random sample from the hedge fund
population but instead tend to contain better performing funds, as poorly performing funds
have little incentive to report to the data services.
The memorandum states that, with respect to risk measurements, several researchers
have concluded that hedge fund strategies appear to be one situation in which the use of
standard deviation, the most commonly used measure of investment risk, is not appropriate.
Because hedge funds do not have bell-shaped normal distributions, hedge funds are more likely
1 SEC Press Rel. No. 64 (May 22, 2003).
2
to have larger losses than would be indicated by the standard deviation of those returns. If
relied on to measure hedge fund risk, standard deviation will typically significantly understate
the actual degree of risk.
The memorandum concludes that hedge funds are significantly more risky than is
commonly portrayed. Investing in hedge funds is a complicated task that requires financial
acumen and advanced analytical tools that are typically beyond the reach of individual
investors. Therefore, given the current state of knowledge, hedge funds or hedge fund
investment strategies would not seem to be warranted for average individual investors.
Linda Brenner
Director - Operations & Continuing
Education
Attachment
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