Hedge Funds

The hedge fund industry has grown phenomenally in terms of assets under management and number of hedge funds in the past 15 years. Hedge funds invest in all capital markets, including emerging markets, and have started to raise capital from the world stock markets. We believe the hedge fund industry has reached another phase in its life cycle.In this chapter, we focus on the performance of hedge funds and the replication of it. We begin with a review of the extant literature on the analysis of the historical performance of hedge funds. Earlier test results on the performance of hedge funds are in general favorable, suggesting excess returns for hedge funds and positive alphas to hedge fund managers. However, studies show that performance persistence was found only in underperformed hedge funds and not in over-performed hedge funds. This suggests that hedge fund performance and hence alpha determination need to be re-evaluated given the hefty performance fees charged by hedge funds. We therefore discuss the survivor, stale-price, and backfill biases that may have caused the measurement error in hedge fund performance and alpha determination. Moreover, we discuss another area of concern in hedge fund performance evaluation — benchmarking. We introduce a sample of non-investable and investable hedge fund indices and discuss their use as benchmarks as the paradigm of performance evaluation has gradually shifted from an absolute-return basis to a relative-return basis. Finally, we introduce several approaches to replicating hedge fund returns.