Hedge-fund benchmarks: Information content and biases

We discuss the information content and potential measurement biases in hedge-fund benchmarks. Hedge-fund indexes built from databases of individual hedge funds inherit the measurement biases in the databases. In addition, broad-based indexes mask the diversity of individual hedge-fund return characteristics. Consequently, these indexes provide incomplete information to investors seeking diversification from traditional asset classes through the use of hedge funds. The approach to constructing hedge fund benchmarks we propose is based on the simple idea that the most direct way to measure hedge-fund performance is to observe the investment experience of hedge-fund investors themselves-the funds of hedge funds (FOFs). In terms of measurement biases, returns of FOFs can deliver a cleaner estimate of the investment experience of hedge-fund investors than the traditional approach. In terms of risk characteristics, indexes of FOFs are more indicative of the demand-side dynamics driven by hedge-fund investors' preferences than are broad-based indexes. Therefore, indexes of FOFs can provide valuable information for assessing the hedge-fund industry's performance.