Fund liquidations must be separated from funds that exit databases for other reasons, if survivorship bias is to be accurately calculated, says new research.
The new research funded by the Foundation for Managed Derivatives Research (FMDR) aims to provide investors with tools for evaluating the potential longevity, or possible liquidation, of hedge funds.
FMDR is a foundation established by Managed Funds Association in 1994 to support scholarly research on the use of derivative instruments. Its new research paper is entitled Competing Risks in Hedge Fund Survival by Fabrice Rouah, McGill University.
As increasing numbers of institutional investors, including pension funds, seek absolute returns through allocations to hedge funds, they also desire long-term investments that will not liquidate prematurely. Selecting hedge funds that are likely to produce consistent returns and remain in operation for a long time is important.
According to Rouah: 'Survival analysis can help them in this regard, since it can provide an additional tool with which investors can perform due diligence on a group of hedge funds. In particular, it can help them select funds with characteristics associated with a long lifetime, and avoid those that are likely to liquidate.' To address this issue, Rouah presents a new model that allows investors to estimate the risk of hedge fund liquidation and identify hedge funds with longevity.
While survivorship bias is well documented, this new research asserts that most of the research treats all funds that exit databases as liquidations, while many have not liquidated but have decided to no longer report their performance and, in fact, have continued to have good returns.
Rouah contends that liquidation must be separated from other exit types. This research estimates survival bias by including liquidated funds only in the dead pool of funds, not funds that have exited performance databases for other reasons.
'The results of this paper have been confirmed by the recent release of Survival Analysis of Hedge Funds by Bank of Japan,' said Richard Oberuc, Chairman, Foundation for Managed Derivatives Research. 'However, this paper by Fabrice Rouah goes beyond the Bank of Japan paper by evaluating the impact of time-varying factors on the survival process."
The results of Rouah's study are summarized as follows:
For a copy of the study, please visit www.mfainfo.org/fmdr.htm 
Background Note: The Foundation for Managed Derivatives Research provides grants for economics, business and financial research that examine, on a scholarly basis, the use of derivative instruments as an investment vehicle. Derivative instruments may include futures contracts, options of futures contracts, forward contracts, and swaps. The growth of these markets has led to increasing involvement by institutions and individuals for investment purposes. As a result, there is demand of academic research considering the advantages and disadvantages of including managed derivatives in investment portfolios. Grants are available to universities, colleges, academic foundations, academic institutions, individuals, and research entities.
Managed Funds Association, headquartered in Washington DC, is the US-based trade association representing professionals who specialize in alternative investment strategies including hedge funds, funds of funds and managed futures funds. MFA has over 1,000 members, which manage a significant portion of the over USD 1.5 trillion invested in hedge funds, including professionals affiliated with over three-quarters of the 50 largest hedge funds.
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