Question

Which of the following is most accurate in describing the problems of survivorship bias and backfill bias in the performance evaluation of hedge funds?

a. Survivorship bias and backfill bias both result in upwardly biased hedge fund index returns.

b. Survivorship bias and backfill bias both result in downwardly biased hedge fund index returns.

c. Survivorship bias results in upwardly biased hedge fund index returns, but backfill bias results in downwardly biased hedge fund index returns.

Short answer

Option a.

Step-by-step solution

Definition of Survivorship bias

Survivorship bias happens when only successful funds are included in the database, and unsuccessful funds cease operation.

-Step 2: Explanation on most accurate description

When unsuccessful funds cease operations, the survivorship bias happens. On the other hand, backfill bias happens when hedge funds add new funds to their index to fill prior return. The index get affected due to removal of non-performing security and arrival of new performing security. This results into upward bias. Hence option (a) is correct.

Incorrect options explanation:

b. Since the non performing securities are ruled out and replaced by a performing security, it will tend to push the returns in the upward direction and not in the downward direction in case of backfill bias. Only successful funds are entailed in survivorship bias. So, it can’t move downwards. Hence option b is incorrect.

c. In case of biased hedge fund index elimination of non-performing securities and substituting them by performing securities will occur and will create a positive impact on the returns and not cause it to go down. Hence, option c is incorrect.