Hostname: page-component-78c5997874-8bhkd Total loading time: 0 Render date: 2024-11-14T22:59:57.860Z Has data issue: false hasContentIssue false
  • English
  • Français

Hedge Fund Performance 1990–2000: Do the “Money Machines” Really Add Value?

Published online by Cambridge University Press:  06 April 2009

Gaurav S. Amin  and
Harry M. Kat
Gaurav S. Amin
Affiliation:
gaurav.amin@schroders.com, Schroder Investment Management Ltd, 31 Gresham Street, London EC2V 7QA, U.K.
Harry M. Kat
Affiliation:
harry@harrykat.com, Cass Business School, City University, 106 Bunhill Row, London EC2Y 8TZ, U.K.
Get access Rights & Permissions [Opens in a new window]

Abstract

We investigate the claim that hedge funds offer investors a superior risk-return tradeoff. We do so using a continuous-time version of Dybvig's (1988a), (1988b) payoff distribution pricing model. The evaluation model, which does not require any assumptions with regard to the return distribution of the funds to be evaluated, is applied to the monthly returns of 77 hedge funds and 13 hedge fund indices from May 1990–April 2000. The results show that, as a stand-alone investment, hedge funds do not offer a superior risk-return profile. We find 12 indices and 72 individual funds to be inefficient, with the average efficiency loss amounting to 2.76% per annum for indices and 6.42% for individual funds. Part of the inefficiency cost of individual funds can be diversified away. Funds of funds, however, are not the preferred vehicle for this as their performance appears to suffer badly from their double fee structure. Looking at hedge funds in a portfolio context results in a marked improvement in the evaluation outcomes. Seven of the 12 hedge fund indices and 58 of the 72 individual funds classified as inefficient on a stand-alone basis are capable of producing an efficient payoff profile when mixed with the S&P 500. The best results are obtained when 10%–20% of the portfolio value is invested in hedge funds.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 38 , Issue 2 , June 2003 , pp. 251 - 274
Copyright
Copyright © School of Business Administration, University of Washington 2003

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Ackermann, C.; McEnally, R.; and Ravenscraft, D.. “The Performance of Hedge Funds: Risk, Return and Incentives.” Journal of Finance, 54 (1999), 833–874.CrossRefGoogle Scholar
Agarwal, V., and Naik, N.. “On Taking the Alternative Route: Risks, Rewards, Style and Performance Persistence of Hedge Funds.” Journal of Alternative Investments, 2 (2000), 6–23.CrossRefGoogle Scholar
Agarwal, V., and Naik, N.. “Characterizing Systematic Risk of Hedge Funds with Buy-and-Hold and Option-Based Strategies.” Working Paper, London Business School (2001).Google Scholar
Amin, G., and Kat, H.. “Welcome to the Dark Side: Hedge Fund Attrition and Survivorship Bias 1994–2001.” Journal of Alternative Investments (forthcoming 2003).CrossRefGoogle Scholar
Black, F., and Scholes, M.. “The Pricing of Options and Corporate Liabilities.” Journal of Political Economy, 3 (1973), 637–654.Google Scholar
Brooks, C., and Kat, H.. “The Statistical Properties of Hedge Fund Index Returns and Their Implications for Investors.” Journal of Alternative Investments, 5 (2002), 26–44.CrossRefGoogle Scholar
Brown, S.; Goetzmann, W.; and Ibbotson, R.. “Offshore Hedge Funds: Survival and Performance.” Journal of Business, 72 (1999), 91–117.CrossRefGoogle Scholar
Chen, Z., and Knez, P.. “Portfolio Performance Measurement: Theory and Applications.” Review of Financial Studies, 9 (1996), 511–555.CrossRefGoogle Scholar
Chernov, M. “A Case of Empirical Reverse Engineering: Estimation of the Pricing Kernel.” Working Paper, Columbia Univ. (2000).Google Scholar
Cox, J., and Huang, C.. “Optimal Consumption and Portfolio Policies when Asset Prices Follow a Diffusion Process.” Journal of Economic Theory, 49 (1989), 33–83.Google Scholar
Cox, J., and Leland, H.. “On Dynamic Investment Strategies.” Journal of Economic Dynamics and Control, 24 (2000), 1859–1880.Google Scholar
Dahlquist, M., and Soderlind, P.. “Evaluating Portfolio Performance with Stochastic Discount Factors.” Journal of Business, 72 (1999), 347–383.Google Scholar
Dybvig, P. “Distributional Analysis of Portfolio Choice.” Journal of Business, 61 (1988a), 369–393.CrossRefGoogle Scholar
Dybvig, P. “Inefficient Dynamic Portfolio Strategies or How to Throw Away a Million Dollars in the Stock Market.” Review of Financial Studies, 1 (1988b), 67–88.Google Scholar
Fung, W., and Hsieh, D.. “Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds.” Review of Financial Studies, 10 (1997), 275–302.CrossRefGoogle Scholar
Fung, W., and Hsieh, D.. “Performance Characteristics of Hedge Funds and Commodity Funds: Natural vs. Spurious Biases.” Journal of Financial and Quantitative Analysis, 35 (2000), 291–307.Google Scholar
Fung, W., and Hsieh, D.. “The Risk in Hedge Fund Strategies: Theory and Evidence from Trend Followers.” Review of Financial Studies, 14 (2001), 313–341.CrossRefGoogle Scholar
Glosten, L., and Jagannathan, R.. “A Contingent Claim Approach to Performance Evaluation.” Journal of Empirical Finance, 1 (1994), 133–160.CrossRefGoogle Scholar
Harrison, J., and Kreps, D.. “Martingales and Arbitrage in Multi-Period Securities Markets.” Journal of Economic Theory, 20 (1979), 381–408.Google Scholar
He, J.; Ng, L.; and Zhang, C.. “Asset Pricing Specification Errors and Performance Evaluation.” European Finance Review, 3 (1999), 205–232.CrossRefGoogle Scholar
Hoggard, T.; Whalley, E.; and Wilmott, P.. “Hedging Option Portfolios in the Presence of Transaction Costs.” In Advances in Futures and Options Research, Chance, D. and Trippi, R., eds., Greenwich, CT: JAI Press, 7 (1994), 21–35.Google Scholar
Jarque, C., and Bera, A.. “A Test for Normality of Observations and Regression Residuals.” International Statistical Review, 55 (1987), 163–172.CrossRefGoogle Scholar
Jensen, M. “The Performance of Mutual Funds in the Period 1945–1964.” Journal of Finance, 23 (1968), 389–416.Google Scholar
KPMG Consulting. “The Coming Revolution of the Hedge Fund Industry: A Case for Growth and Restructuring.” Discussion Paper, KPMG Peat Marwick LLP (1998).Google Scholar
Leland, H. “Option Pricing and Replication with Transaction Costs.” Journal of Finance, 40 (1985), 1283–1301.Google Scholar
Liang, B. “On the Performance of Hedge Funds.” Financial Analysts Journal, 55 (1999), 72–85.CrossRefGoogle Scholar
Liang, B.. “Hedge Fund Performance: 1990–1999.” Financial Analysts Journal, 57 (2001), 11–18.CrossRefGoogle Scholar
Lo, A. “Risk Management for Hedge Funds: Introduction and Overview.” Financial Analysts Journal, 57 (2001), 16–33.CrossRefGoogle Scholar
Merton, R. “On Market Timing and Investment Performance. I. An Equilibrium Theory of Value for Market Forecasts.” Journal of Business, 54 (1981), 363–406.Google Scholar
Mitchell, M., and Pulvino, T.. “Characteristics of Risk and Return in Risk Arbitrage.” Journal of Finance, 56 (2001), 2135–2175.Google Scholar
Pelsser, A., and Vorst, T.. “Transaction Costs and Efficiency of Portfolio Strategies.” European Journal of Operational Research, 91 (1996), 250–263.Google Scholar
President's Working Group on Financial Markets. “Hedge Funds, Leverage and the Lessons of Long-Term Capital Management.” Report of the President's Working Group on Financial Markets (1999).Google Scholar
Sharpe, W. “Mutual Fund Performance.” Journal of Business, 39 (1966), 119–138.CrossRefGoogle Scholar
Sharpe, W.. “Asset Allocation: Management Style and Performance Measurement.” Journal of Portfolio Management, 18 (1992), 7–19.Google Scholar