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Hedge Fund Industry: Declining Performance and Increasing Risk?

| | Posted in: Mutual/Hedge Funds

Is the hedge fund industry an alpha-generating juggernaut? Does it even really offer a “hedge?” In their March 2006 paper entitled “Hedge Funds: Performance, Risk and Capital Formation”, William Fung, David Hsieh, Narayan Naik and Tarun Ramadorai investigate performance, risk and capital flows within the hedge fund industry over the past ten years. Using a comprehensive dataset of 1,603 Funds-of-Hedge-Funds (FoFs) covering the period 1995-2004, they find that:

  • The equal-weighted net (after fees) mean returns for FoFs average 9.4% per year over the sample period, with large variations across funds within years and across means from year to year. (See the chart below.)
  • The overall industry delivered excess risk-adjusted returns only during October 1998 to March 2000. The segment of individual FoFs delivering excess risk-adjusted returns varies from a low of 10% to a high of 42% over the ten-year period.
  • The hedge fund industry in general exhibits high exposure to risk.
  • There are FoFs that persistently outperform the market, supporting a view that some managers have superior ability.
  • Outperforming FoFs steadily attract new money, but their excess returns diminish substantially as money under management grows. The flow of new money into the overall hedge fund industry has significantly depressed industry-wide performance.

The following chart, constructed from data in the paper, illustrates several of these findings. It shows the strong recent growth of assets under management for FoFs. It shows the wide variability of annual industry returns, and it shows that industry growth has dampened returns.

In summary, hedge fund industry net risk-adjusted returns are unremarkable and declining. The flow of new money to hedge funds may pressure hedge fund managers to take greater risks.

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