A Critical Look at the Case for Hedge Funds

Abstract

Hedge funds are supposed to be largely market-neutral, meaning their returns exhibit relatively little correlation with market returns. One often hears that they make money in down markets as well as up. To the extent that hedge fund returns are uncorrelated with market returns, and the funds earn a positive risk premium, a hedge fund allocation would be generally indicated for efficiently diversified portfolios. In fact, the evidence is that diversified hedge fund investment is not market-neutral; significant, persistent market exposures and a high degree of market correlation are identified here. Diversified hedge fund portfolios also exhibit a surprising degree of variability in factor exposures over time, revealing the limits of hedge fund style diversification and indicating a herding tendency. Hedge funds have not demonstrated the ability to make money in a down market, but rather a good sense of market timing in coping with the U.S. stock market bubble. Neither performance nor cost considerations warrant hedge fund inclusion in balanced portfolios.