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FRM Part II · FRM Exam Part II · Hedge Fund Investment Strategies

A database of hedge fund returns is built from funds that voluntarily report to a vendor. Funds with poor results often stop reporting and are then deleted from the database, so only surviving funds remain in historical averages. Which bias does this describe, and what is its typical effect on reported average returns?

This is survivorship bias. Funds that perform poorly stop reporting and are dropped, so the database contains mainly successful funds. As a result, average historical returns are overstated, and risk may also look lower than the true experience of all funds that existed.

  1. ASurvivorship bias, which overstates average historical returnsCorrect
  2. BBackfill bias, which understates average historical returns
  3. CSelection bias, which understates historical volatility only
  4. DSurvivorship bias, which understates average historical returns

Explanation

When poorly performing funds exit and their histories are removed, the remaining sample is made up of better performers. Average returns are therefore biased upward. Understating returns would be the wrong sign for this bias.

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