Hedge Funds: What Do We Know?

Hedge funds are attracting increased attention because of their reputation for earning superior (risk‐adjusted) returns. Hedge Fund Research Inc. estimates that in 2001 there were about 7,000 hedge funds with investor capital of about $600 billion. And yet the diversity of hedge funds, combined with a general lack of transparency, makes the hedge fund industry something of a “black box.” This article provides an overview of the legal structure of hedge funds, the various fund investment strategies, and the existing research on overall hedge fund performance. Without uniform and comprehensive reporting requirements, it is difficult to ascertain the size and scope of hedge fund investments. Nonetheless, current research provides persuasive evidence that hedge funds earn positive risk‐adjusted returns, on average, in contrast to their counterparts in the mutual fund industry. In an attempt to explain these higher returns, the authors begin by noting that hedge funds are subject to considerably less regulation than other investment institutions because their client base is limited to wealthy individuals and institutions. Hedge funds can thus employ investment strategies that mutual funds and pension funds are prohibited from pursuing, such as short selling, high leverage, derivatives, concentrated holdings, and limited redemptions. As a result, the funds may be able to earn excess returns by operating in illiquid and specialized markets where there is a shortage of arbitrage capital. At the same time, and perhaps even more important, hedge funds are in a better position than conventional mutual funds to attract skilled managers because of their use of performance‐based incentive fee structures.