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Hedge Funds

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Some very wealthy investors invest in Hedge Funds.  Hedge Funds are similar to mutual funds, but they are more risky, less regulated, less liquid, and dramatically more expensive (not only do they have annual expense ratios of about 2%, but they typically take 20% or more of all gains as well).  We discourage use of Hedge Funds because they are so very expensive and because virtually all of them are actively managed.

"If you want to waste your money, it's a good way to do it." "If you want to invest in something where they steal your money and don't tell you what they're doing, be my guest." — Dr. Eugene Fama, commenting on the prudence of investing in hedge funds

"If there's a license to steal, it's in the hedge fund arena." — Dr. Burton Malkiel, commenting on the high costs of hedge funds

"It takes about 35 years of returns to say with any statistical confidence that stocks have a higher expected return than the risk-free rate. Think about a hedge fund that has equity-like volatility. If the manager’s alpha was as large as the market risk premium — which would be huge — it would also take about 35 years to be confident the manager has any value added — and that’s before his fees of '2 and 20.' Even if that phenomenal manager is out there, is he likely to stick around long enough for us to be able to figure out he wasn’t just lucky?" — Dr. Kenneth French, commenting on the probability of being able to determine that any particular hedge fund manager had ANY skill.

Vikas Agarwal and Narayan Y. Naik, "Multi-Period Performance Persistence Analysis of Hedge Funds," London Business School Working Paper, February 2000 (95kb). This study concludes that there may be some very short term persistence, but it is primarily the poor performers whose performance appears to persist — persistence among good performers is dramatically less.  This suggests that it may not make sense to pick a Hedge Fund based on past performance (but it may make sense to avoid those with particularly poor past performance).

Clifford Asness, Robert Krail, and John Liew, "Do Hedge Funds Hedge?," Journal of Portfolio Management, Fall 2001, pp. 6-19 (242kb).  Also here.  This excellent paper looks at the risk-adjusted performance of Hedge Funds. It notes that illiquidity of underlying investments, among other effects, tends to distort performance numbers. Specifically, it notes that hedge fund performance tends to lag the performance of the market. After taking that effect into account, it doesn't appear that Hedge Funds are very good at "hedging".

Chris Brooks and Harry M. Kat, "The Statistical Properties of Hedge Funds Index Returns and Their Implications for Investors," The University of Reading, October 31 2000 (108kb). "Sharpe Ratios will substantially overestimate the true risk-return performance of (portfolios containing) hedge funds.  Similarly, mean-variance analysis will over-allocate to hedge funds and overestimate the attainable benefits from including hedge funds in an investment portfolio."

Bernard Condon, "Hedge Fund Investing For Dummies," Forbes, May 14 2004. "Warning to hedge fund investors: You would do better giving your money to a monkey."  You may have to register (for free) to read this article.

Richard M. Ennis and Michael D. Sebastian, "A Critical Look at the Case for Hedge Funds: Lessons from the Bubble," The Journal of Portfolio Management, Summer 2003, pp. 103-112 (235kb). "Notwithstanding evident market timing skill — at least during the extraordinary period covered here — the performance of hedge funds has not been good enough to warrant their inclusion in balanced portfolios.  The high cost of investing in funds of funds contributed to this result.  Many practitioners believe markets are imperfectly efficient, providing astute investors an opportunity to exploit security mispricing.  This may well be true.  One wonders, though, how realistic it is to expect funds of hedge funds to realize competitive returns for their investors after costs upward of 5% per year."

David Harper, "Introduction to Hedge Funds - Part Two: Advantages and Questions,", December 10 2003. A good discussion of Hedge Funds for laypeople.

William Jahnke, "Hedge Funds Aren't Beautiful," Journal of Financial Planning, February 2004, pp. 22-25.  Also here.  "Hedge funds are a great product for the hedge fund industry and its support apparatchik ... but are likely, on average, to produce a negative return contribution relative to a benchmark consisting of stocks, bonds, and cash."  A scathing review of the utility (or lack thereof) which hedge funds might have for investors.

Burton Malkiel and Atanu Saha, "Hedge Funds: Risk and Return," Financial Analysts Journal, NovemberDecember 2005, pp. 80-88.  Also here.  "We conclude that hedge funds are far riskier and provide much lower returns than is commonly supposed."
Alejandro Murguía and Dean T. Umemoto, "An Alternative Look at Hedge Funds," Journal of Financial Planning, January 2004, pp. 42-49.  Also here.  An outstanding, frank discussion of hedge funds.  "Advisors relying on simple return data and traditional evaluation measures presented in many hedge fund tear sheets will be vulnerable to inaccurate conclusions and possibly expose their clients’ investments to an inappropriate amount of risk."  "Although this [hedge fund] manager may seem to be providing excess returns, a multifactor model that incorporates the dynamic trading strategy of the fund will indicate that the fund manager is essentially creating these returns by taking on more risk through the specific trading strategy and not necessarily through alpha."

" Until further advances are made [in empirical research on what drives hedge fund returns], advisors may be better served by diversifying their clients’ portfolios with other un-represented asset classes traded on major exchanges such as emerging markets or international small cap stocks. These different asset classes have traditionally been very effective portfolio diversifiers. Additionally they allow advisors a degree of liquidity and transparency not currently present in hedge funds."

Michael W. Peskin, Michael S. Urias, Satish I. Anjilvel, and Bryan E. Boudreau, "Why Hedge Funds Make Sense," Morgan Stanley Dean Witter, November 2000 (820kb). This often-cited paper concludes that Hedge Funds are beneficial for institutional investors.  However, before going out and buying any Hedge Funds, be sure to view the other studies listed here.

Christopher B. Philips, "Understanding Alternative Investments: A Primer on Hedge Fund Evaluation," The Vanguard Group, January 2005. A good primer on Hedge Funds.

Nolke Posthuma and Pieter Jelle Van Der Sluis, "A Reality Check on Hedge Funds Returns," Working Paper, July 8 2003 (218kb). This paper finds that backfill bias causes Hedge Fund return databases to systematically overstate actual realized returns by about four percent per annum.  This brings into serious question any and all studies which might conclude that hedge funds are beneficial.

William Reichenstein, "What are you Really Getting When You Invest in a Hedge Fund?," AAII Journal, July 2004. "... a review of the historical returns of hedge funds and other alleged advantages finds them suspect."

Thomas Schneeweis, Hossein Kazemi, and George Martin, "Understanding Hedge Fund Performance: Research Results and Rules of Thumb for the Institutional Investor, "Center for International Securities and Derivatives Markets, University of Massachusetts, November 2001 (1.2mb). An outstanding discussion of various topics surrounding Hedge Funds.

Neil Weinberg and Bernard Cohen, "The Sleaziest Show On Earth," Forbes, May 24 2004. "Hedge funds will suck in $100 billion this year from an ever-broader swath of investors. Pretty good for a business rife with exorbitant fees, phony numbers and outright thievery."  You may have to register (for free) to read this article.

Andrew B. Weisman and Jerome D. Abernathy, "The Dangers of Historical Hedge Fund Data." (62kb) This paper presents a means of describing performance characteristics of Hedge Fund managers.  It also points out two troubling biases which tend to be present in the data.  It calls these biases "Short-Volatility Bias" and "Illiquidity Bias."  These biases tend to cause Hedge Fund performance data to understate the actual riskvolatility of the funds (and therefore overstate risk-adjusted performance).

Andrew B. Weisman, "Informationless investing and hedge fund performance measurement bias: dangerous attractions," Journal of Portfolio Management, Summer 2002, pp. 80-91. This paper describes how three phenomena typical of hedge funds each conspire to overstate the risk-adjusted performance of Hedge Funds (and understate their correlation with other assets).  The result is that most hedge fund database data is significantly biased, calling into question any conclusions based on them.

Martin Sewell's Hedge Fund Bibliography.  An excellent bibliography of relevant papers on this topic — most with full text.

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