Hedge Funds and Hedge Fund Investing

Actual Hedge Fund Returns

As of September 2012, there were ~10,000 hedge funds, which collectively held $2.5 trillion in assets (source: eVentment/HFN). From 1980 through 2008, hedge funds averaged 12.6% a year (source: Ilia Dichev, Emory University, and Gwen Yu, Harvard). However, hedge fund investors only experienced a net return of 6.0% per year (largely due to chasing top performers after they experienced a large return). Over the same period, mutual fund investors underperformed mutual fund benchmarks by 1.5% per year by chasing hot performers (e.g., 9.4% vs. 10.9% for the S&P 500).  

Types of Hedge Funds

Generally, hedge funds fall into one of two categories: risk reducers or return enhancers. Morningstar lists over 250 mutual funds as “alternatives”—funds that use a hedge fund–type approach. Investors also have the option of using “replicator” mutual funds and ETFs (e.g., Goldman Sachs Absolute Return Tracker, Natixis ASG Global Alternatives, IQ Alpha Hedge Strategy, Marketfield Fund, and Merger Fund).

Understanding Hedge Fund Returns

Recent research shows hedge funds receive much of their return by owning assets that lack liquidity during market panics. This “liquidity-risk premium” translated into 10.6% annual returns from 1996 through 2009 versus 4.1% per year for hedge funds that had much more liquidity (source: Ronnie Sadka, Boston College).

Hedge Fund Risks

All hedge fund investors and advisors should be concerned with “operational risks.” These hedge funds use a little-known accounting firm that relies on its own model to value assets and makes trades using its own brokerage arm.