Hedge Funds: Risk and Return

ince the early 1990s, hedge funds have become an increasingly popular asset class. The amount invested globally in hedge funds rose from approximately $50 billion in 1990 to approximately $1 trillion by the end of 2004.1 And because these funds characteristically use substantial leverage, they play a far more important role in the global securities markets than the size of their net assets indicates. Market makers on the floor of the NYSE have estimated that during 2004, trades by hedge funds often accounted for more than half of the total daily number of shares changing hands. Moreover, investments in hedge funds have become an important part of the asset mix of institutions and even wealthy individual investors. We examine a reasonably comprehensive database of hedge fund returns and estimate the magnitude of two substantial biases that can influence measures of hedge fund performance in the data series. The reader will see that these biases may be far greater than has been estimated in previous studies. In this article, we discuss our construction of a database that is relatively free of bias and examine not only the returns of hedge funds but also the distinctly nonnormal characteristics of their returns. We also investigate the substantial attrition of hedge funds, analyze the determinants of hedge fund demise, and provide the results of tests of return persistence.