Hedge Funds and Hope

Abstract

The long bull market left many with significant assets to invest, not to mention higher return expectations. Hedge funds have had explosive growth because they offer to satisfy these expectations. Return data from hedge funds of funds, across various hedge fund investment styles, suggest that this perception is not based on anecdotes. A closer examination of the return data and its distributional properties reveals a less sanguine picture. The author argues that a prototypical hedge fund has properties that are attractive and should be part of a sensible portfolio. He then describes adjustments to returns and portfolio construction techniques to account for the special features of hedge funds. It is shown that the proportion of a prudent portfolio invested in hedge funds is much lower than naive analysis would suggest.