Evaluating Hedge Fund Performance

CHAPTER 2

It's the Risk, Not the Return

Using Hedge Funds to Reduce Portfolio Risks

The diversification and downside risk protection benefits of hedge funds have long been recognized by sophisticated investors. But it took the 2000 bear market for hedge funds to gain acceptance by a wider audience.

Though by early 2003 the worst equity market decline in 70 years was coming to an end, this knowledge came only with the benefit of hindsight, for investors could not recognize the end of the bear market any more than the beginning of the burst of the bubble in 2000. Every day, strategists and money managers of all stripes continued to pound the table, predicting the worst was yet to come. To this day, although the tempo of the alarm has receded, the outlook has only changed from a state of depression to deep anxiety mixed with hopes and remembrances of the good old days.¹ In the meantime, by 2003 savvy investors had not failed to notice that many hedge funds produced positive returns, sometimes exceeding the 30 percent or more previously found only during the market bubble. In this atmosphere, hedge funds emerged as an attractive investment option. With losses piling up in the previous three years as the stock market continued to produce red ink with no end seemingly in sight, individuals and institutions alike were drawn to hedge funds in their search for a safe haven.

Sometimes wealthy individuals who had invested in hedge funds and were well connected with the industry led the charge ...