Explanation:
Hedge Funds: The exclusion of funds that discontinue reporting creates survivorship bias. Funds typically stop reporting when their performance is poor. By excluding these underperforming funds, the remaining database overstates the true average return of the hedge fund universe, leading to an overestimated mean Sharpe ratio.
Real Estate Funds: Appraising illiquid assets only annually results in return smoothing. This infrequent valuation masks the true market fluctuations, leading to an underestimated volatility. Since volatility is the denominator in the Sharpe ratio calculation, artificially low volatility results in an overestimated mean Sharpe ratio.
Therefore, both issues lead to an overestimation of the mean Sharpe ratio for their respective fund types.
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Q.2581 Samuel Ray, a risk analyst at Alpha Investments Bank, is evaluating the annual performance data of hedge funds and real estate funds for investment purposes. He takes note of two significant concerns:
A
The mean Sharpe ratio of hedge funds is underestiminated, and the mean Sharpe ratio of real estate funds is overestimated.
B
The mean Sharpe ratio of both hedge funds and real estate funds is overestimated.
C
Both hedge funds and real estate funds show an overestimated average volatility.
D
Hedge funds present an overestimated average volatility, while real estate funds show an underestimated average volatility.