High Water Mark Bias - A New Hedge Fund Index Bias
7 Pages Posted: 21 Dec 2014
Date Written: September 29, 2014
There are a variety of different approaches to benchmarking hedge fund strategies, however peer-based or manager aggregate indices remain the most widely used. Biases that exist within these indices affect the ability of an investor to fully understand the return characteristics of a given strategy. In this paper we add to the existing literature by documenting a new hedge fund index bias – High Water Mark Bias (“HWM Bias”).
Rather than being a database bias, this bias is a practical issue as result of the propensity for hedge funds to charge a performance fee, typically with a high water mark, and it describes one particular issue for investors seeking to replicate hedge fund indices.
The paper include both a empirical study of the bias using the Newedge CTA Index, and provides a theoretical framework for quantifying the HWM Bias for any index. We show the key factors to be; the frequency of rebalancing, the number of “managers” turned over within a portfolio, the average drawdown depth for the index constituents, and the future return path for new allocations.
Keywords: Hedge Funds, Index, Alternative Investments, Index Bias, Investing Bias, Hedge Fund Portfolio Constuction, Hedge Fund Replication, Hedge Fund Bias
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