A Pervasive Index Bias

I was amused in this blogging heads video when these guys note that art indices have a huge survivorship bias to them. Don't they all.


Most asset indices are presented by groups with a strong vested interest in the asset in question, which is more so the more illiquid the asset.

There’s a clear bias by all data providers to overstate the returns in the indices they present. For example, Malkiel and Saha (2005) found that no hedge fund data base providers has the last year of Long Term Capital Management in their dataset, excluding the -92% return, and so the indexes exclude the very risks that make hedge fund investors nervous. Malkiel and Saha estimate this bias adds approximately 6% to the annualized returns. Who creates these indices? Usually groups that are allied with the product one is examining. For example, the Credit Suisse/Tremont Index that monitors hedge fund returns is maintained by the following:

The joint venture, Credit Suisse Tremont Index LLC, combines the considerable expertise of Credit Suisse, one of the world's leading global investment banking firms, and the data research group of Tremont Capital Management, Inc., a full-service hedge fund of funds investment management firm.

It is an inevitable conflict of interest where those most knowledgeable, and have access to the best data, will be advocates of this field—one does not become extensively knowledgeable in something one thinks is irrelevant, inefficient, or fraudulent. Often times there’s an arm’s length separation between the index provider and the portfolio managers, but there is no way they can be indifferent: without the market thriving, seeming to offer a good opportunity, their service will not have a long life. After all, it was conventional wisdom that active portfolio managers outperformed passive indices until the 1980’s—for several generations—because the evidence was generally held and presented by the active managers and their industry groups. It was based on the intuitive idea that someone managing a portfolio is obviously better than merely buying an indiscriminate, equal weighting of equities. So issues like using closing prices to calculate total returns, while in very liquid markets a benign assumption, in illiquid markets is a material error.