THE spectacular investment returns of the hedge fund industry were thrown into doubt yesterday as Barclays Capital said that the figures were being exaggerated by as much as 6 percentage points a year.

The flattering picture of the industry had emerged as a result of imperfections in the way many hedge fund indices were compiled, it said. The investment bank put the typical level of overstatement at 1 to 6 percentage points per year, depending on the index.

Even an overstatement of 1 per cent per year would mean that hedge funds — billed as the best-performing asset class over ten years — had in fact been outpaced by shares.

If it were 6 per cent, it would mean that hedge funds were in fact producing less than half the annual investment returns of 11 to 12 per cent routinely claimed for them.

Tim Bond, author of the highly regarded Equity Gilt Study, said: “If you take some indices at face value, you are getting a flattering picture of the industry.” Some investors could be misled, he said.

However, he emphasised that, after taking account of these biases, hedge fund managers were still worth their high fees because performance was down to skill and not just market movements.

Barclays outlined a series of methodological failings by index compilers, including survivorship bias — the tendency to ignore funds as soon as they close or fail. This alone added between 2 and 4 per cent a year to index performance figures, according to academic studies, Barclays said.

Another study estimated the effect of survivorship bias at 2.44 per cent on an index where all funds were treated equally, and 0.85 per cent for weighted indices.

Barclays said returns were also exaggerated because of selection bias, the result of some hedge fund managers choosing not to report figures, especially when they have performed poorly.

A third problem was known as instant history bias: funds tend to wait for a period of strong performance before publishing their figures and entering an index. This strong performance is then backdated into the index.

Two large hedge fund index compilers, Credit Suisse/Tremont and Standard & Poor’s, declined to comment on the report.

Between 1994 and 2005, US shares produced an average annual return of 10.6 per cent, just outpaced by hedge funds, which according to Credit Suisse/Tremont, produced an 11 per cent average annual return.

The findings come as the Financial Services Authority signalled it was prepared to see hedge funds take on more debt, describing current levels of leverage as “moderate”.

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