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Evaluating Hedge Fund Performance by VINH Q. TRAN

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CHAPTER 4

The Skewed Statistics of Hedge Fund Returns

Past Results Are Not Necessarily Indicative of Future Performances

Attracted by hedge funds' strong returns during the three-year equity bear market, investors flocked to hedge funds in 2003. Looking over the longer term, they were impressed by studies and analyses showing that hedge funds have produced better risk-adjusted returns than stocks and bonds. Armed with the teachings of modern portfolio theory and statistics such as standard deviation and Sharpe ratio, analysts pored over the records of hedge fund indexes provided by CSFB/Tremont, Hedge Fund Research, TASS, and others. The conclusions were seemingly inescapable. Over time, hedge funds, so said the indexes, have produced returns similar to—and sometimes higher than—those of the major stock market indexes such as the S&P 500, while exhibiting lower volatility of returns. Outperformances of hedge funds would have been higher if transaction costs and management fees had been deducted from the S&P index's returns because hedge fund returns were net of all expenses and fees. Furthermore, hedge funds exhibited low correlation with the stock market, meaning they were capable of producing positive returns even when the stock market declined.

The combination of similar returns and lower risk (therefore higher risk-adjusted returns), coupled with low correlation, acts as a powerful rationale for investing in hedge funds. Why would anyone not prefer lower risks for similar and ...

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