Sunday, February 04, 2007

Asset Class Reader: Hedge Funds

Hedge Funds, with access restricted to "sophisticated, wealthy investors" and institutions, have been the recipients of large cash inflows from investors seeking to diversify "traditional" investment portfolios. Hedge Fund investment comes at a heavy price (2% of assets under management and 20% of profits is the common expense loading) as well as with complex return attributions which require a deep (and for the novice, often bewildering) statistical analysis to determine their utility as additions to a portfolio. How does one measure hedge fund returns, and how do hedge funds measure up as investments? The following series of papers examine these issues:

Understanding Alternative Investments: A Primer on Hedge Fund Evaluation

Vanguard Investment Counseling and Research

Executive summary
Sparked by the 2000–2002 equity bear market and fueled by general expectations of lower future returns for stocks and bonds, popular opinion has embraced the idea that hedge funds can deliver positive returns regardless of the direction and magnitude of stock and bond market returns. As a result, hedge funds have garnered considerable attention as a viable alternative investment. But is such enthusiasm justified? What have been the risk-adjusted returns of hedge funds? And what are the risks of hedge fund investing? This report examines the characteristics and historical performance of a common set of hedge fund strategies available to investors. While we find that most hedge funds operate in a risk-controlled framework, we caution that investing in hedge funds may not be as simple or safe as often portrayed. Indeed, this report concludes that:

• Reported hedge fund returns contain significant biases that skew conventional mean-variance and regression analysis.
• Distinct and enduring differences exist between opportunistic and non-directional strategies.
• Because of serious data limitations, quantitative analysis of hedge funds should be supplemented by qualitative judgment.

Hedge Funds: Past, Present and Future

Stulz, René M., "Hedge Funds: Past, Present and Future" . Fisher College of Business Working Paper No. 2007-03-003

Assets managed by hedge funds have grown faster over the last ten years than assets managed by mutual funds. Hedge funds and mutual funds perform the same economic function, but hedge funds are largely unregulated while mutual funds are tightly regulated. This paper compares the organization, performance, and risks of hedge funds and mutual funds. It then examines whether one can expect increasing convergence between these two investment vehicles and concludes that the performance gap between hedge funds and mutual funds will narrow, that regulatory developments will limit the flexibility of hedge funds, and that hedge funds will become more institutionalized.

Superstars or Average Joes? A Replication-Based Performance Evaluation of 1917 Individual Hedge Funds

Kat, Harry M. and Palaro, Helder P., "Superstars or Average Joes? A Replication-Based Performance Evaluation of 1917 Individual Hedge Funds" (February 3, 2006)

In this paper we use the hedge fund return replication technique recently introduced by Kat and Palaro (2005) to evaluate the net-of-fee performance of 1917 individual hedge funds. Comparing fund returns with the returns on dynamic futures trading strategies with the same risk and dependence characteristics, we find that no more than 17.7% of the hedge funds in our sample beat the benchmark. In other words, the majority of hedge funds have not provided their investors with returns, which they could not have generated themselves by mechanically trading S&P 500, T-bond and Eurodollar futures. Over time, we observe a substantial deterioration in overall hedge fund performance. In addition, we find a tendency for the performance of successful funds to deteriorate over time, which supports the hypothesis that increasing assets under management endanger future performance.

Welcome to the Dark Side: Hedge Fund Attrition and Survivorship Bias over the Period 1994-2001

Kat, Harry M. and Amin, Gaurav S., "Welcome to the Dark Side: Hedge Fund Attrition and Survivorship Bias over the Period 1994-2001" (December 11, 2001)

Hedge funds exhibit a high rate of attrition that has increased substantially over time. Using data over the period 1994-2001, we show that lack of size, lack of performance and an increasingly aggressive attitude of old and new fund managers alike are the main factors behind this. Although attrition is high, survivorship bias in hedge fund data is quite modest, which reflects the relatively small difference in performance between surviving and defunct funds. Concentrating on survivors only will overestimate the average hedge fund return by around 2% per annum. For small, young, and leveraged funds, however, the bias can be as high as 4-6%. We also find significant survivorship bias in estimates of the standard deviation, skewness and kurtosis of individual hedge fund returns. When not corrected for, this will lead investors to seriously overestimate the benefits of hedge funds. We find fund of funds attrition to be much lower than for hedge funds. Combined with a small difference in performance between surviving and defunct funds of funds, this yields relatively low survivorship bias estimates for funds of funds.

The Statistical Properties of Hedge Fund Index Returns and Their Implications for Investors

Kat, Harry M. and Brooks, Chris, "The Statistical Properties of Hedge Fund Index Returns and Their Implications for Investors" (October 31, 2001)

The monthly return distributions of many hedge fund indices exhibit highly unusual skewness and kurtosis properties as well as first-order serial correlation. This has important consequences for investors. We demonstrate that although hedge fund indices are highly attractive in mean-variance terms, this is much less the case when skewness, kurtosis and autocorrelation are taken into account. Sharpe Ratios will substantially overestimate the true risk-return performance of (portfolios containing) hedge funds. Similarly, mean-variance portfolio analysis will over-allocate to hedge funds and overestimate the attainable benefits from including hedge funds in an investment portfolio. We also find substantial differences between indices that aim to cover the same type of strategy. Investors' perceptions of hedge fund performance and value added will therefore strongly depend on the indices used.

Harry Kat, the academician who has exhaustively researched hedge funds, has posted many more papers on hedge funds and synthetic funds (which replicate hedge fund performance and risk metrics using managed futures at dramatically lower cost loadings.) You can find Dr. Kat's research at Cass Business School, City of London. Dr. Kat is also a principle in a firm he has founded to create and manage synthetic funds.

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