About Hedge Funds: What You Need to Know
Hedge funds are privately organized investment entities that commonly take both long and short positions in securities and derivatives contracts and employ the use of financial leverage.
Hedge funds are usually organized as limited partnerships or limited liability companies and have strict minimum investment and net worth requirements.
Equity Hedge Funds: Common strategies are market neutral (zero beta portfolios), net short, and long/short.
Fixed Income Hedge Funds: May use leverage to generate returns on yield spread relationships.
Performance Measurement Challenges
Historically, hedge funds are thought of as investments designed to generate positive returns in both bull and bear markets.
Because of their unique characteristics, it is difficult to measure hedge fund performance with traditional benchmarks and risk-adjusted return measures. Some of these unique characteristics include:
- In the large universe of hedge funds, there are many styles and sub-styles.
- Limited public disclosure requirements for funds.
- High portfolio turnover.
- Large and/or changing degrees of leverage.
- Style drift.
Hedge Fund Benchmarks
- Hedge Fund Indexes: CSFB/Tremont offers several style based hedge fund benchmark indexes.
- Hedge Fund Index pitfalls: Voluntary fund listing, potential exclusion of large funds, no way to validate data.
- Pitfall sources: Turnover of index funds, short histories for some funds, survivorship bias, autocorrelation causing misestimates of volatility, and closure of some funds to new investors.
- Market Indexes: some market indexes can be useful in assessing hedge fund returns, while others not so much. The Merrill Lynch High Yield Index may work well for assessing returns on some fixed income hedge funds and the Russell 3000 Index may work well for assessing returns on some equity hedge funds. With this in mind, market indexes generally cannot be used to explain hedge fund returns.
- Positive Risk Free Rate: Given the expectations of hedge funds to generate positive returns in any market, the risk free rate plus some additional margin is sometimes used as a benchmark. Funds may be benchmarked against an absolute return or an index return plus a margin. A positive risk free rate of return may be technically appropriate for only market neutral funds.