CFA Level 1 Alternative Investments - Hedge Funds - 4

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LOS

l. discuss the performance of hedge funds, the biases present in hedge fund
performance measurement, and explain the effect of survivorship bias on the
reported return and risk measures for a hedge fund database;
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Performance of hedge funds

Various indexes of hedge funds are available from consultants and fund managers.

Some of them are:

CISDM
Zurich Capital Management and MAR
CSFB/Tremont
VAN
Henesse
EACM 100
HFR
Carr/Barclays for CTAs

Based on the indices Solnik and Mcleavey conclude that there is a strong case for investing in hedge funds.

Hedge funds tend to have a net return (after fees) higher than equity markets and bond markets.

Hedge funds tend to have lower risk(measured by standard deviation of past returns) than traditional equity investments.

Higher Sharpe ratio indicates higher return for a unit of risk. For hedgefunds, data providers do calculate Sharpe ratio and was found to be higher than that for equity investments for the period 1996-2002. But Solnik and Mcleavey raise the caution that Sharpe ration may not be an appropriate measure for hedge funds as they have option like characteristics.

The correlation of hedge fund returns with conventional bonds and equities is positive but low.

Attraction for talent: The fee structure and flexibility of investment options is attracting talented fund managers. When both and long positions and short positions can be taken research insights can be used either way. Also leverage can be employed to magnify the benefit from an insight.

Caveats or cuations:

Investors need to exercise caution in using the available historical performance data on hedgefunds. The hedge fund industry does not adhere to rigorous performance presentation standards as it is not a regulated activity with uniform reporting formats. While past winners may not repeat, certain known biases can make it difficult to interpret the hedgefund performance data. The biases identified are:

Self selection bias

Instant history bias

Survivorship bias

Smoothed pricing - Infrequently traded assets

Option like investment strategies

Fee structure and gaming

There is a very large pool of capital chasing after what is likely to be a limited supply of pricing inefficiencies. Any successful trading strategy will quickly be imitated by many other fund managers, thereby reducing the profitability of the strategy. Investors need to exercise great caution in interpreting and extrapolating the reported performance of hedge funds; there is possibility of underestimating risk.