Self-Selection Bias

The term self-selection describes the situations in which people select themselves into a group. In such situations the people’s characteristics force them to behave in a certain manner. An example would be a contractual guarantee, which forces vendors of inferior products to leave the market because the guarantee is too costly for them.

However, the vendors with good-quality products remain in the market because they can afford to offer the guarantee. The self-selection bias is the systematic distortion resulting from the fact that the remaining sample of vendors does not correspond to the general population of vendors.

In the hedge fund industry, self-selection exists because of the voluntary basis of data reporting. Unlike mutual funds, the managers of hedge funds are not required to disclose performance numbers or any other information to anyone else than their current investors.

Hence, only some hedge fund managers report information to the data providers. Small funds with a good track record have an especially strong incentive to report performance numbers in order to attract new investors. However, if the fund is sufficiently large or the track record is bad, the hedge fund manager may decide not to report information to the data providers.

As only the most successful funds have an incentive to report past performance, the sample of hedge funds reporting information to a data provider does not necessarily represent the general hedge fund population. Hence, the mean return of the hedge fund in the database might be higher than the mean return of all hedge funds.

Self-Selection Bias