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Hedge funds: an industry in its adolescence

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  • William K.H. Fung
  • David A. Hsieh
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    Abstract

    The dramatic increase in the number of hedge funds and the "institutionalization" of the industry over the past decade have spurred rigorous research into hedge fund performance. This research has tended to uncover more questions than answers about the dynamic and multifaceted hedge fund industry. ; This article presents a simple hedge fund business model in which fund returns are a function of three key elements -- how the funds trade, where they trade, and how the positions are financed. The article also provides methods to help investors, intermediaries, and regulators identify systemic risk factors inherent in hedge fund strategies. ; Estimating these risk factors requires having an accurate history of hedge fund performance. The authors examine recent statistics from three commercial hedge fund databases and discuss the problems with database biases that must be recognized to obtain accurate measures of returns. ; While the data show that today's hedge funds use myriad strategies that have no uniform definition, the proposed business model implies that hedge fund managers are diversifying in order to maximize the enterprise value of their firms. But this diversification does not preclude the risk of leveraged opinions converging onto the same set of bets. Preventing convergence risk will require action by investors, intermediaries, regulators, and fund managers to improve industry-level disclosure and transparency while preserving the privacy of individual hedge funds' positions.

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    Bibliographic Info

    Article provided by Federal Reserve Bank of Atlanta in its journal Economic Review.

    Volume (Year): (2006)
    Issue (Month): Q 4 ()
    Pages: 1-34

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    Handle: RePEc:fip:fedaer:y:2006:i:q4:p:1-34:n:v.91no.4

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    Keywords: Hedge funds;

    References

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    1. Jonathan B. Berk & Richard C. Green, 2002. "Mutual Fund Flows and Performance in Rational Markets," NBER Working Papers 9275, National Bureau of Economic Research, Inc.
    2. Jennifer N. Carpenter, 2000. "Does Option Compensation Increase Managerial Risk Appetite?," Journal of Finance, American Finance Association, vol. 55(5), pages 2311-2331, October.
    3. Fung, William & Hsieh, David A, 1997. "Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds," Review of Financial Studies, Society for Financial Studies, vol. 10(2), pages 275-302.
    4. William N. Goetzmann & Jonathan Ingersoll, Jr. & Stephen A. Ross, 1998. "High Water Marks," NBER Working Papers 6413, National Bureau of Economic Research, Inc.
    5. Franklin R. Edwards, 2006. "Hedge funds and investor protection regulation," Economic Review, Federal Reserve Bank of Atlanta, issue Q 4, pages 35-48.
    6. Liang, Bing, 2000. "Hedge Funds: The Living and the Dead," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 35(03), pages 309-326, September.
    7. Jennifer Carpenter, 1999. "Does Option Compensation Increase Managerial Risk Appetite?," New York University, Leonard N. Stern School Finance Department Working Paper Seires 99-076, New York University, Leonard N. Stern School of Business-.
    8. Duarte, Jefferson & Longstaff, Francis A. & Yu, Fan, 2005. "Risk and Return in Fixed Income Arbitage: Nickels in Front of a Steamroller?," University of California at Los Angeles, Anderson Graduate School of Management qt6zx6m7fp, Anderson Graduate School of Management, UCLA.
    9. Anne Jansen & Donald J. Mathieson & Barry J. Eichengreen & Laura E. Kodres & Bankim Chadha & Sunil Sharma, 1998. "Hedge Funds and Financial Market Dynamics," IMF Occasional Papers 166, International Monetary Fund.
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    Cited by:
    1. Benjamin Auer, 2013. "The low return distortion of the Sharpe ratio," Financial Markets and Portfolio Management, Springer, vol. 27(3), pages 299-306, September.
    2. Wegener, Christian & von Nitzsch, Rüdiger & Cengiz, Cetin, 2010. "An advanced perspective on the predictability in hedge fund returns," Journal of Banking & Finance, Elsevier, vol. 34(11), pages 2694-2708, November.
    3. Steven Malliaris & Hongjun Yan, 2008. "Nickels versus Black Swans: Reputation, Trading Strategies and Asset Prices," Yale School of Management Working Papers amz2380, Yale School of Management, revised 01 Mar 2009.
    4. Dichev, Ilia D. & Yu, Gwen, 2011. "Higher risk, lower returns: What hedge fund investors really earn," Journal of Financial Economics, Elsevier, vol. 100(2), pages 248-263, May.
    5. Roman Tancar & Jan Viebig, 2008. "Alternative beta applied—an introduction to hedge fund replication," Financial Markets and Portfolio Management, Springer, vol. 22(3), pages 259-279, September.
    6. Auer, Benjamin R., 2014. "Should hedge funds be cautious reporting high returns?," Research in International Business and Finance, Elsevier, vol. 30(C), pages 195-201.
    7. Zhiguo He & Arvind Krishnamurthy, 2008. "A Model of Capital and Crises," NBER Working Papers 14366, National Bureau of Economic Research, Inc.
    8. Arvind Krishnamurthy & Zhiguo He, 2009. "A Model of Capital and Crises," 2009 Meeting Papers 85, Society for Economic Dynamics.

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