Introduction
Hedge funds are one of increasingly popular and the fastest growing financial instruments of the late 20th century and nowadays. The number of all hedge funds has gone up sharply since 80s both in the United States and non-US markets, resulting a tremendous increase in the total asset value invested in this field. Ackermann et al. (1999) indicates that annual increase in the total number of hedge funds has been more than 25 percent and by 1997 hedge funds were managing a total sum of more than $200 billion. Therefore it can be reasonable to associate such rapidly growing field with superior performance. To investigate hedge fund performance and characteristics, considerable number of research has been done in 90s and 2000s. Since in this assignment, the main aim is to focus on hedge fund ability of generating excessive return, empirical research based on hedge fund return and risk features is used. Moreover, the effect of some hedge fund characteristics on their risk and return features is also explained in order to discuss better whether it is possible for a hedge fund to create a persistent excess return.
Ability to Generate Excess Return
Hedge funds differ from mutual funds and most of other classical instruments in numerous regulatory or executive ways. However the most important aspects which make hedge funds desirable in terms of their excess return may be indicated as less restricted complex trading strategies and reduced agency problem through higher concentration on management incentive and commitment. Firstly, it would not be wrong to state that one of the most significant properties of hedge funds is that they have highly unregulated structures relative to other organisations. The main reason for this is that entry to hedge funds is limited, thus number of investors of funds does not most of the time exceed 100. Therefore, they are exempt from some of the investment company laws. Liang (1999) explains how being unregulated can be an advantage for hedge fund investors by using the taxation example. According to Liang, ability to use non-conventional trading strategies such as short sales can be counted as one of the factors that contribute to excess returns of hedge funds. By using short sales, hedge fund manager can take position in two ways and this flexibility grants him or her ability to exploit bearish market and equity movements as well as bullish movements. Reasoning of this argument is well accepted in academia. French and Ko (2006) also support this argument by stating that as well as the ability of rapid leveraging and de-leveraging, the ability of short selling enables fund managers to amplify their exposure and returns. This is an important feature of hedge funds which mutual fund managers are not able to enjoy. They use a sample of 157 long/short hedge funds to test against market, which is S&P500 in this case, and find that vast majority of these funds generate a high excess return in bullish market conditions, whereas their average return appear to be close to market return in bearish market conditions. On the other hand, being unregulated also causes some shortcomings that will be explained later.
Another factor that is believed strongly contributes to superior return performance of hedge funds is the high management incentive fees, which are based on fund performance. To explain how high incentive based system can help obtaining higher yields, Ackermann et al. state that managers get 1 percent as annual management fee as their only regular salary. However sole management fee does not constitute a great contribution to a manager’s wealth. Apart from this amount, managers receive incentive fees. A very significant feature of the incentive fee is that fund managers receive incentive only if they perform better than a given rate and, clear fund losses and generate profit. This sort of an incentive fee scheme can greatly contribute to excess return generation and better management commitment, resulting reduced agency problem.
One of the highest-class empirical researches concerning hedge fund returns has been done by Fung and Hsieh (1997). This paper investigates hedge fund performance according to their risk return profiles. Their findings support hedge funds have superior risk return profiles, meaning it is possible to obtain better return for the same amount of risk that investor gets exposed to. Furthermore, they express that this superiority is mainly caused by their low correlation with the market, which results lower systematic risk. Amin and Kat (2002) concludes that a better risk return portfolio can be obtained by adding hedge funds in but with a cost of worse skewness and kurtosis properties.
Problems Associated with Returns and Biases
From investors’ perspective, unfortunately it may not be sufficient to analyse hedge fund excess returns just by looking at their average returns in general. In other words, although many scholars have found that the majority of hedge funds do generate excess returns, some characteristics of hedge fund returns might result with a question mark in investors’ mind. First of all, strong evidence has been found by Manser and Schmid (2009) on hedge funds’ inadequate return persistence due to high volatility. In their observation, consisting between 1994 and 2006, after hedge funds were ranked by their performance for each year, it was realised that very good and very bad performing hedge funds of one year could rarely manage to persist same performance for the adjacent year. Consequently, these findings have confirmed earlier claims that there was virtually no yearly persistence in hedge fund return performances (Brown et al., 1999; Agarwal and Naik, 2000).
Apart from these, while analysing hedge fund returns, problem of obtaining biased data is also confronted. There are several major biases that are hidden inside the yield data of hedge funds (Asness et al. 2001). The first and probably the most common of these is the survivorship bias. This bias arises due to exclusion of dead funds in return data. Consequently, a database one has would have unrealistic high return in average. Moreover, since hedge funds are highly unregulated, they are not obliged to disclose their return statistics and this might also push the bias towards the positive end of the performance distribution. In addition to these, Asness et al. found that backfill and self-selection biases also play an important role in hedge fund data from past years not being totally realistic.
Conclusion
Most empirical work concerning hedge fund returns used databases after 1994 to minimise survivorship bias. Overall, many of these work has concluded that hedge funds are able to generate excess returns. Especially during bullish market conditions, hedge funds are capable of highly outperform the market. The most important factors contributing to hedge fund ability to generate excess return appear to be flexible investment strategies enjoyed by fund managers and, high management involvement and incentive. However, it should not be forgotten that the statistical information collected on past hedge fund performances are not perfectly reliable due to their non-transparent nature. Therefore, every further research in this field must be aware of biases. In addition, even though hedge funds yield excess returns, majority of their performances appear to be not persistent on long term and short term persistence cannot be fully benefited by investors due to long lock up periods.
