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Financial Happenings Blog
Thursday, September 14 2006

When we see the studies of investment performance, it is clear that active managed funds on average fail to beat the lower cost and simpler investment strategy of investing in an index fund.

However there remains another factor lurking behind these reports, in the form of 'survivorship bias'.  Survivorship bias works like this.  If you are measuring investment returns over a period, say 10 years, then over that time some managed funds would collapse.  These managed funds are generally not included in the research.  However, the fact that they tend to fail suggests that their performance is poor, and therefore overlooked.

A study by some professors from the University of Massachussets, which looked at hedge funds, provided some interested statistics on this topic.  Hedge funds were divided into 6 categories.  For those funds that failed, their returns were more than 10% lower than the successful funds in 4 out of the 6 categories.  The other two categories had differences of 8.9% and 5%.  This is a massive difference in performance, with the bad performance hidden from the public by the fact that the funds went out of business.

This makes it hard for consumers to know what is happening in any part of the managed funds industry, as they are only hearing the story of the good funds, rather than the funds that have gone out of business and let investors down.

I am not a fan of hedge funds at all.  They are basically trading funds, that rely on the skill of the expensive investment manager.  The fact that they are trading funds makes them tax ineffective.  I remain unconvinced of the existence of publicly available trading skill that will result in superior 10 year hedge fund returns against investing in traditional asset classes.  Hedge funds often sell themselves on the fact that the returns are 'uncorrelated' with other investment classes.  Betting on horse 2, race 3 is also uncorrelated with other investment classes, however I would not advise it.

My thoughts: if you want to get rich start a hedge fund, don't invest in one.

Posted by: Scott Francis AT 08:02 pm   |  Permalink   |  Email
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