Evaluating Hedge Fund Performance

Introduction

Alfred Winslow Jones started a hedge fund in 1949, pioneering the concept and strategy of using hedges to protect his portfolios against market declines. Though hugely successful and producing handsome returns for his investors, and imitated by others in the subsequent decades, Jones' idea did not gain much recognition among the investing public in the 1980s and 1990s, who were fixated by the bull market and the popularity of mutual funds. In fact, TASS Research identified only 68 hedge fund managers when it began collecting data on hedge funds in 1984. But all of that changed with the bear market of 2000–2002, which witnessed unrelenting stock market declines for the longest period since the crash of 1929. While mutual fund and other traditional investors were reeling in losses, investors in many hedge funds suffered little and sometimes stacked up double-digit percentage gains. As a result, assets under management by hedge funds soared from about $200 billion in 2000 to over $500 billion in 2003, and have reached over $1 trillion by 2005—still small compared to about $8 trillion managed by approximately 8,300 U.S.-based mutual funds but nevertheless representing dramatic growth.

But even now, reports about hedge funds remain largely negative. Press headlines such as “Hedge-Fund Follies,”¹ “Hedge Funds May Give Colleges Painful Lessons,”² and “A Health Warning on Hedge Funds”³ clearly are not intended to soothe.

The reality is that hedge funds are investments with ...