With stock and bond markets unlikely to deliver the stellar returns of the last 25 years, hedge funds have become increasingly popular among investors. The growth in this asset class in the last 15 years is nothing short of phenomenal. The hedge fund industry has developed a multitude of strategies aimed at generating much more alpha than long-only managers have been able to produce. Some of these strategies are actually hedged against market risk, while others are directional with significant market risk.

The record for returns is impressive. These returns are large whether they are measured in absolute terms or relative to market benchmarks. Alphas higher than 5 percent are found for some hedge fund strategies. Hedge fund returns do not extend back very far since most databases were only developed in the 1990s. But the biggest problem is that these returns are plagued with backfill and survivor bias. Once you adjust for these biases, the returns look much less impressive.

When investing in hedge funds, manager skill is everything. And that skill is very unevenly distributed. The gap between the top-performing and lower-performing manager is far larger than for traditional asset classes. Manager selection and manager access are absolutely crucial to successful hedge fund investing. Does that mean that an investor should choose a fund of funds? The answer must weigh the advantages of a fund of funds manager, due diligence and expertise in choosing ...

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