RD 24: Alternative Investments EOC # 42 : Statement 3
“It is better to use an equally weighted hedge fund index to reflect the potential diversification of hedge funds rather than a value-weighted index. This is because value weighting may result in the index taking on the return characteristics of the best-performing hedge funds, creating a momentum effect in returns.”
Can anyone explain?
Hedge Fund Indices are subject to survivorship bias. With value weighted, some of your larger players are going to play a larger part in their contribution to the overall performance in the index, and the return on the index is going to be inflated. With an equal weighted, each component of the index(each hedge fund) is given an equal weight, thereby solving the issue.
Although hedge fund indices do suffer from suvivorship bias, I don’t think that passage in the OP’s post refers to that characteristic.
I think it’s just more simple than that…as the most successful hedge funds gain in size, their weighting in the index grows, and they start to dominate the returns characteristics of the index as a whole. If the biggest hedge fund in the index counts for 90% of the index as a whole, and the rest just count for the remaining 10% - when you analyse the return charactestics of the overall index, they will be very similar to the characteristics of the largest hedge fund.
For example, max drawdowns and volatility for the index will be heavily influenced by the max drawdown and volatility of the 90% weighted fund.
As the index is then biased towards large, successfull hedge funds, this is where the momentum effect comes in. The hedge fund is more successful, it gains even more weight in the index meaning a reinforcing effect.