Hedge Funds: Risk and Return

From a database that is relatively free of bias, this article provides measures of the returns of hedge funds and of the distinctly nonnormal characteristics of the data. The results include risk-adjusted measures of performance and tests of the degree to which hedge funds live up to their claim of market neutrality. The substantial attrition of hedge funds is examined, the determinants of hedge fund demise are analyzed, and results of tests of return persistence are presented. The conclusion is that hedge funds are riskier and provide lower returns than is commonly supposed. Hedge funds have become an increasingly popular asset class since the early 1990s. The amount invested globally in hedge funds rose from approximately $50 billion in 1990 to approximately $1 trillion at the end of 2004. And because these funds characteristically use substantial leverage, they play a far more important role in the global security markets than the size of their net assets indicates. Market makers on the floor of the NYSE have estimated that during 2004, trades by hedge funds often accounted for more than half of the total daily number of shares changing hands. Moreover, investments in hedge funds have become an important part of the asset mix of institutions and even wealthy individual investors. Hedge funds are marketed as an “asset class” that provides generous returns during all stock market environments and thus serves as excellent diversification for an all-equity portfolio.This article reports our study of a reasonably comprehensive database of hedge fund returns. We examine the magnitude of two substantial biases that can influence measures of hedge fund performance in the data series—backfill bias and survivorship bias. We conclude that these biases may be far greater than has been estimated in previous studies. We examine not only the returns of hedge funds but also the distinctly nonnormal characteristics of the returns. We also investigate the substantial attrition of hedge funds, analyze the determinants of hedge fund demise, and provide the results of tests of return persistence.We show that the practice of voluntary reporting and the backfilling of only favorable past results can cause returns calculated from hedge fund databases to be biased upward. Moreover, the considerable attrition that characterizes the hedge fund industry results in substantial survivorship bias in the returns of indices composed of only currently existing funds.Correcting for such biases, we found that hedge funds have lower returns than is commonly supposed. Moreover, although the funds tend to exhibit low correlations with general equity indices and, therefore, are excellent diversifiers—hedge funds are extremely risky along another dimension: The cross-sectional variation and the range of individual hedge fund returns are far greater than they are for traditional asset classes. Thus, investors in hedge funds take on a substantial risk of selecting a dismally performing fund or, worse, a failing one.