The Truth about Hedge Funds

At the end of 2012, assets in hedge funds had grown to a record $2.25 trillion from $488 billion in 2000, according to Hedge Fund Research. Today, because individual investors have joined institutional investors, hedge funds seem almost mainstream. So, should you invest?  By design, that’s hard to say.

Hedge funds are not required to disclose standardized performance information, and that thwarts performance measurement. What’s more, they lack transparency, so it’s even more difficult to determine if their high fees (a median 1.5% management fee plus a 20% “incentive” fee) are “worth it.”

A 15-year study of hedge fund performance by Roger Ibbotson, Kevin Zhu, and Peng Chen sought to separate the purported skill of hedge fund managers from the market returns. In particular, the researchers wanted to identify what portion of hedge fund returns came from alpha and what portion came from beta.

The results will surprise some. More than 60% of the returns of hedge funds came from stock market beta. Further, the researchers found that returns were strongly correlated with those of the overall stock market. Thus, investors using hedge funds as a hedge to enhance portfolio diversification would have been disappointed. In fact, in 2008, hedge funds were down as much as 20%, which was highly correlated with the stock market.

In the end, hedge funds generated slightly higher returns than the S&P 500 over the course of the 15 years. However, once fees were subtracted, the hedge funds’ performance was lower than that of the long-only equity portfolios.

In other words, the higher returns generated by the hedge funds did not cover the additional fees they charged. So, while hedge funds may sound glamorous, clearly all that glitters is not gold.

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