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Exhaustive and complete data on hedge funds are impossible to obtain. But the imperfect available
data concludes that hedge funds have been very successful in the 1990s.
Why is it difficult to obtain information about the performance?
Hedge funds are pirvate partnerships and corporations which are sold through private offerings of
security. They are subject to no direct regulations beyond the basic security regulations. They are
not required to report to any public regulator and not allowed to publically advertise and promote
their funds. As a result, no concrete source of exhaustive audited data on hedge funds performance
or asset management exists.
Some organizations specialise in gathering and selling data on hedge funds, thereyby advicing and
helping potential investors to select the right fund.
Data is gathered by surveying the find managers which might result in added systematic
imperfections in the collected data.
Definition of universe
Depending on the organization, they may chose to exclude finds that do no use leverage or shor
selling. Some include managed futures funds etc. Hence, distinctions between them are quite
blurred.
Completenes of universe
Since there is no single, exhaustive uniform source for benchmarking these funds,
it is not possible to capture all funds in the sureveys.
New funds are added frequently and vendors become aware of them only through word of
mouth.Hence the database is not complete.
Participation in surveys is prely voluntary and some fund managers chose not to participate for two
reasons – either they fared poorly or have enough investments and thereby not interested to promote
or advertise their funds.
Omission of these two groups leads to over or understating of average performance respectively.
Over the time, many funds are dropped when they cease to exist, which inturn causes historical
performance that now reflects only the good funds that still survive to overstate past performance.
With all these, it's been observed that a net overstatement (mainly due to overstated historical
results) of average performance of the group.
Conclusion drawn from data
Exhibit2. Growth of Hedge Funds
Managed Account Reports (MAR) admits that the raw data needs to be grossedup by a factor of 3.0
to catpture funds that have not been captured in the survey.
This factor was chosen so that our resulting esitmate of total funds under management matches the
current consensus of $300 to $400 billion. This also complies to the study done by Eichengreen and
Mathieson [1998] who chose 2.7 after discussions with other data vendors. This gross up factor is
constant in time and doest not contribute to the pattern of rapid growth
Indiacators for hedge funds growth used here are – Number of funds in existence and the aggregate
assets under management. The curve clearly indicated the raising popularity and growth of hedge
funds in 1990s.
Exhibit3. Risk/Return Performance as a class over time
Group Analysis
Here we compare several major performance benchmarks during the 1990s and estiamte the
risk/return performance of the Hedge funds.
Results 142 funds from the MAR database are taken as a group, as well as divided into segment
subgroups.
For the hedge fund universe and segments, monthly fund returns are averaged on equalweighted
basis, and their gemorteric averages and standard deviations are calculated across time.
Results are multiplied by 12 and (12)½ to convert them to annualequivalent basis. Benchmark used
are the S&P 500 (exhibit 3), Russell 2000, MSCI EAFE, MSCI Emerging markets index and the
Lehman US Bond index. All hedge funds returns are net of fees.
The data supports the assertion that hedge funds have exhibited strong risk/return performance
during 1990s. They have outperformed all benchmarks except the S&P 500, and at lower risk than
all benchmarks but the Lehman US Bond index. Furthermore, ratio of return to risk is clearly higher
for the hedge fund universe than others.
Segmented Analysis
Macro funds turned in highest return, while funds of funds exhibited lowest return. This is a
contradiction to the fact that funds of funds seek to select funds that will turn in the strongest
performance.
Average return and standard deviation through time of the average monthly return across all funds in
each category using an equal weighted investment in 142 hedge funds simultaneously.
Such an Hypothetical investment enjoys significant diversification, especially in hedge fund
portfolios which are largeley uncorelated to one another.
Exhibit4. Risk/Return Performance on average over time
This represents the risk and return experienced by the average fund in each class, rather than by the
class as an aggregate. We observe that the average returns are unchanged but risk estimates are
significantly increased (graphically, all hedge funds point shift to right, leaving benchmark points
fixed)
We also see that the average hedge fun experienced same risk as S&P 500 but delivered lower
return. Their risk continues to be lower than all other benchmarks except the bond benchmark but
still gave higher returns.
Contrary to our previous observations, this observation does not make a great case for the hedge
funds.
Conclusion from Exhibit3 and Exhibit4
1. Investors cannot practically invest in all 142 funds simultaneously. They would prefer to
invest in 3 or 4 funds. This will shift the risk levels to the left, closer to the one depicted in
exhibit3
2. Comparison to S&P is a bit unfair in 1990s due to the bull run and as hedge funds are mostly
100% net long, they tend to be less corelated to the market
Hence, historical pattern of risk and return for S&P is not a reasonable estimate of its
expected risk and return of the future.
Exhibit5. Effecient Frontier with/without Hedge Funds
In the above exhibit, expected returns and covariances are calculated on basis of monthly returns
from January 1991 to September 1998. Hedge fund asset used is the average hedge fund.
We observe that the set of feasible portfolios is expanded significantly when hedge funds are
available. It increases the portfolio return by as much as 200 basis points.
Both frontiers terminate on the right in the single highest return asset, the S&P 500. The left
terminates at different points which are the portfolios withe the least risk under the respective
assumptions.
Important conclusion for the above exhibit is that the average hedge funds seems to have lower risk
and higher returns compared to other benchmarks except S&P. The returns are closer to the S&P
and even though they are not highly corelated.
This is a powerful combination as it enables investor to lower risk significantly without degrading
return by forming a portfolio combining hedge funds and the S&P.
Exhibit6. Performance of Hedge funds during the down quarters of S&P
Hedge funds have continously outperformed the S&P during the poor quarters which further
strengthens our argument of the consistent and low corelated performance of Hedge funds compared
to the S&P
Conclusion
We have looked at various exhibits that compares the hedge funds as a group and as an average,
against major benchmarks. Even with an incomplete and a conservative estimation, Hedge funds
seem to have outperformed major benchmarks (except S&P) by giving consistent high returns for
lower risks even in low quarters.This is a powerful combination as it enables investor to lower risk
significantly without degrading return by forming a portfolio combining hedge funds and the S&P.