Why the average hedge fund looks great

Question

A commercial database reports that the average hedge fund in a category returned $15\%$ per year over the last decade.

Why is this likely too optimistic, and how would you measure the category's true performance?

Accepted Answer

The bias. Funds that performed badly do not stay in the database. When a fund blows up, closes, or merges away, it stops reporting and is often dropped, so the surviving sample is skewed toward winners. This is survivorship bias, and a second effect compounds it: backfill bias, where a fund is only added to the database after a good early run, and its strong prior returns are then filled in retroactively. A toy illustration. Suppose 10 funds start the decade. Three of them have a disastrous year (say -50\% each) and shut down, vanishing from the database. The other seven survive and average +…

Why the average hedge fund looks great

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