Benchmarks of Hedge Fund Performance: Information Content and Measurement Biases

Abstract

This paper discusses the information content and potential measurement biases in hedge fund benchmarks. Hedge fund indices built from databases of individual hedge funds will inherit their measurement biases. In addition, broad-based indices mask the diversity of individual hedge fund return characteristics. Consequently, these indices are less informative for investors seeking diversification from traditional asset classes through the use of hedge funds. This paper proposes a different approach to constructing hedge fund benchmarks. It is based on the simple idea that the most direct way of measuring hedge fund performance is to observe the investment experience of hedge fund investors themselves. In terms of measurement biases, returns of funds-of-hedge funds can deliver a cleaner estimate of the investment experience of hedge fund investors. In terms of risk characteristics, indices of funds-of-hedge funds is more indicative of the demand side dynamics driven by hedge fund investors' preferences. Therefore, indices of funds-of-hedge funds can provide additional valuable information to the assessment of the hedge fund industry's performance.