3 reasons indexes in traditional finance are broken

The collective investment performance of the hedge fund industry has been poor for a decade, as represented by HFR's indices but how much better are indexes in traditional finance?

Let's try to implement calculations purporting to describe valuations, performance and risk measures of derivatives and passive indices. There are several significant misconceptions and wild inaccuracies. The numbers you read from such sources are at best biased and flawed.

There are three main ratios to look at,

1. Sharpe ratio - It all depends what you are comparing the index to, i.e. Is it the overnight, 1 year or 1 month deposit rate? Is it some other other index? which one? The 5 year Treasury rate or the negative EU overnight deposit rate? Yes it is the latter for a dominant European exchange that has 8000 + indices. Is it hard to beat minus 0.37% PA? Believe it or not that is the so called risk free rate against which they are comparing all their 8000 indices in terms of Sharpe Ratio. Is it corrected for linear correlation? No. Take any batch of data and you will get wildly different answers for Sharpe ratio from each source, because everyone does is differently to suit their book. That is a fact. You read total non-sense from these exchanges.

2. Turnover - When a fund buys and sells it incurs costs. When an exchange quotes annualised or raw performance for its so called passive indices; they do not factor in turnover costs. Highly misleading to compare a real life return over an index that ignores costs of bid offer spreads on stocks they buy and sell when the fund is reconstituted and rebalanced on a quarterly semi annual or annual basis. How? because as already specified they accept or reject a stock when reconstituting thousands of their indices every year or quarter.

3. Survivor-ship bias - a charge often levelled at only hedge funds. Well the stocks in so called passive indices flogged by exchanges, mentioning no names, are not passively selected by any stretch of the imagination. Many are capitalisation weighted, others are equal weighted but highly themed and focused on over hyped investment fads and fancies. They kill off under performers or tightly held shares while investing in the latest super companies. If the exchange publishes data on 8000 to 20,000 different indices, how can they all be described as passive? They are not. With increasing demands for exchange traded funds and centrally cleared instruments, these indices are more like exotic derivatives of the old days dressed up as a passive fund , created and marketed by the investment banks that caused the 2008 debacle. Wolves dressed up as lambs, again fooling the public and the regulators.

So hedge funds may come and go but so too do the constituents of the passive indices that owned these papers in which we read the hedge fund bashing studies. The difference is we all hear of the 20% performance fees taken by hedge fund managers but we read stats for indices that ignore their turnover costs and their currency hedging costs when expressing performance.

The stats we read are nonsense.