The Performance of Hedge Funds: Risk, Return, and Incentives

TLDR

Hedge funds exhibit flexible strategies, strong managerial incentives, substantial personal investment, sophisticated investors, and limited regulation, all of which may affect performance. The study examines how six data‑conditioning biases influence hedge fund performance. Using 1988–1995 data, hedge funds consistently beat mutual funds but not market indices, are more volatile than both, and while incentive fees partly explain higher returns, they do not account for the increased risk; survival‑related biases appear to offset each other.

Abstract

Hedge funds display several interesting characteristics that may influence performance, including: flexible investment strategies, strong managerial incentives, substantial managerial investment, sophisticated investors, and limited government oversight. Using a large sample of hedge fund data from 1988–1995, we find that hedge funds consistently outperform mutual funds, but not standard market indices. Hedge funds, however, are more volatile than both mutual funds and market indices. Incentive fees explain some of the higher performance, but not the increased total risk. The impact of six data‐conditioning biases is explored. We find evidence that positive and negative survival‐related biases offset each other.