(May 8, 2012) — Hedge funds’ extensive use of derivatives, short-selling, leverage, and their dynamic trading strategies fuel the often superior strength of many of these investment vehicles, according to a newly released academic paper.
Yet, hedge funds’ low correlations with other financial securities tend to dissipate during stressful market events, making them less useful for diversification than they may appear, the paper’s authors assert, adding that hedge fund returns are reduced by management and incentive fees.
According to the academic paper titled “Do Hedge Funds Outperform Stocks and Bonds” — written by Georgetown University’s Turan G. Bali, Stephen J. Brown from New York University, and Sabanci University’s K. Ozgur Demirtas — Quantitative Directional, Equity Hedge, and Emerging Market hedge fund strategies outperform the US equity market. Meanwhile, for an investment horizon of one year, only Macro and Relative Value hedge fund strategies outperform the 1-month and 10-year Treasury securities, whereas for long-term investment horizon of five years, almost all hedge fund portfolios dominate the US Treasury market.
“However, the remaining 11 hedge fund strategies considered in the paper do not generate superior performance over the S&P500 index,” the authors claim.
The takeaway message, Georgetown University’s Bali tells aiCIO, is that investors tend to use traditional performance measures, such as Sharpe ratio, which fail to rank the relative performance of hedge fund portfolios. “We found that hedge funds do outperform but not by traditional measures — hedge fund investors should thus compare their entire return distribution, not just mean and standard deviation,” he says.
The paper continues: “Although there are obvious reasons why one may not allocate a high proportion of assets into hedge funds, many fund strategies outperformed similarly-risky investment options during the recent crisis period. Hence, it is not clear whether hedge funds dominate stocks and bonds.”