Journal of Financial and Quantitative Analysis · 2003 · 62 citations · 0 references
BusinessEconomicsFinanceFinancial EconomicsInvestment ManagementPortfolio ManagementHedge FundsInvestmentInvestment FundsPortfolio TheoryReturn AnalysisRisk-return AnalysisCost-risk Trade-offEfficiency LossFee Structure AnalysisHedge Fund Fee StructuresHedge Fund ReturnsInvestment Performance EvaluationReturn-risk Trade-off AnalysisRisk-return Trade-offs
The study examines whether hedge funds provide a superior risk‑return tradeoff for investors. Using a continuous‑time payoff‑distribution pricing model that makes no return‑distribution assumptions, the authors evaluate monthly returns of 77 hedge funds and 13 indices from 1990 to 2000. Results show that hedge funds alone do not deliver a superior risk‑return profile; 12 indices and 72 funds are inefficient, with average losses of 2.76% and 6.42% per year, but when combined with the S&P 500 most become efficient, especially with a 10–20% allocation.
We investigate the claim that hedge funds offer investors a superior risk-return tradeoff. We do so using a continuous-time version of Dybvig's (1988a), (1988b) payoff distribution pricing model. The evaluation model, which does not require any assumptions with regard to the return distribution of the funds to be evaluated, is applied to the monthly returns of 77 hedge funds and 13 hedge fund indices from May 1990–April 2000. The results show that, as a stand-alone investment, hedge funds do not offer a superior risk-return profile. We find 12 indices and 72 individual funds to be inefficient, with the average efficiency loss amounting to 2.76% per annum for indices and 6.42% for individual funds. Part of the inefficiency cost of individual funds can be diversified away. Funds of funds, however, are not the preferred vehicle for this as their performance appears to suffer badly from their double fee structure. Looking at hedge funds in a portfolio context results in a marked improvement in the evaluation outcomes. Seven of the 12 hedge fund indices and 58 of the 72 individual funds classified as inefficient on a stand-alone basis are capable of producing an efficient payoff profile when mixed with the S&P 500. The best results are obtained when 10%–20% of the portfolio value is invested in hedge funds.