The Only Guide to Alternative Investments You'll Ever Need: The Good, the Flawed, the Bad, and the Ugly

Chapter 15. Hedge Funds

Rex Sinquefield, retired cochairman of Dimensional Fund Advisors (DFA), made this important observation: "Just because there are some investors smarter than others, that advantage will not show up. The market is too vast and too informationally efficient."^[102]

Thus, while it is possible that hedge fund managers may be investment experts, the presence of special skills is one—but not the only—condition necessary for success. Trading costs, management fees, administrative fees, incentive fees, and tax inefficiency are all costs that are borne by investors in hedge funds. To make matters worse, investors accept the risks of potentially poor diversification of assets. Therefore, the question becomes this: Do hedge fund managers have enough skill to compensate for all the costs (and incremental risks) incurred?

The 2001 study "Hedge Fund Performance 1990-2000: Do the 'Money Machines' Really Add Value?" by Harry M. Kat and Gaurav S. Amin, investigated whether hedge funds did indeed offer investors a superior risk-adjusted return profile.^[103] Because hedge fund returns may exhibit a high degree of nonnormality (that is, fat tails) as well as a nonlinear relationship with the stock market—rendering the use of traditional performance measures questionable—the study used a dynamic trading-based performance measure that does not require any assumptions about the distribution of fund returns.

The study covered thirteen hedge fund indexes and seventy-seven individual funds. ...