CFA Practice Question

There are 139 practice questions for this study session.

CFA Practice Question

An analyst compared the performance of a hedge fund index with the performance of a major stock index over the past eight years. She noted that the hedge fund index (created from a database) had a higher average return, higher standard deviation, and higher Sharpe ratio than the stock index. All the successful funds that have been in the hedge fund database continued to accept new money over the eight-year period. What biases do the risk and return measures in the database most likely have? Average return:
A. and standard deviation are both overstated.
B. is overstated and standard deviation is understated.
C. is understated and standard deviation is overstated.
Explanation: Survivorship bias affects both the returns and the risk (standard deviation) reported for the hedge funds. Hedge funds with low or negative returns will be excluded from the index as will funds with high volatility; those funds will not survive for eight years. If only the successful funds remain in the index, the returns are overstated and risk is understated. Overstated returns and understated risk will both tend to overstate the Sharpe ratio.

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