The Hedge Fund Chimera

The FT has a piece today that quietly dissects some of the inherent problems in imputing high performance to hedge funds. While there is ample reason to believe that lifting the short-selling contraint can improve portfolio performance, there is also ample reason to be suspicious of current hedge funds (over-)stated results:

Whereas just 5 per cent of hedge funds closed in 1994, about 15 per cent would close this year, he said. Failure to look at closed funds overestimated returns by 2-4 per cent.

In addition, new hedge funds took 32 months on average to register on databases. This resulted in returns not including companies that had closed before they registered. Prof Kat said research from the Netherlands showed these omissions resulted in returns being overestimated by 3-4 per cent.

The two hidden factors combined meant overall returns were 6-8 per cent lower than generally realised.

And there’s more, as the FT points out. Fundamentally the hedge fund asset class is a young investment category, and that comes with consequences:

…there was only 10 years of hedge fund data, and then only in the unusual environment of a strong bull market followed by a sharp downturn.

In addition, there were now 6,000 hedge funds compared with just 500 in 1990.

“We don’t know what is normal for hedge funds. For stocks we have two centuries of data,” said Prof Kat.