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

A database of hedge fund returns is built only from funds that are still reporting today. Funds that stopped reporting after poor performance or liquidation are removed from the history. Which bias does this most directly create, and what is its usual effect on reported average returns?

This is survivorship bias. Excluding funds that stopped reporting after poor results leaves only the successful ones, so the database's average historical return is overstated relative to the full population of hedge funds that actually existed.

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

Explanation

Removing dead funds leaves only successful ones, so the average return of the surviving sample is higher than that of the full population. Option D has the right name but the wrong direction. Backfill bias arises from adding prior history when a fund joins the database, and smoothing relates to illiquid pricing.

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