The Return in Hedge-Fund Strategies

ABSTRACT This paper deeply examines the difference between traditional and absolute return hedge funds. It also described the development and characteristic of hedge funds as well as the different types of hedge fund investments. In addition, it also surveys some of the pitfalls that investors face when they try to make investment decisions using hedge fund data from commercial sources. Although hedge funds are often branded as a separate asset class, a point can be made that hedge fund managers are simply asset managers utilizing other strategies than those used by relative return (long-only) managers. The major difference between the two is the definition of their return objective: Hedge funds aim for absolute returns by balancing investment opportunities and risk of financial loss. Long-only managers, by contrast, define their return objective in relative terms. JEL: G1, G11, G12 Keywords: Hedge fund; Portfolio management I. INTRODUCTION Since the early 1990s, there has been a growing interest in the use of hedge funds among both institutional and private investors. (1) Due to their private nature, it is difficult to obtain adequate information about the operations of individual hedge funds and reliable summary statistics about the industry as a whole. Hedge funds are claimed to have been among the few bright spots in the investment world for the last two years. But just how well these alternative investment vehicles stack up against stocks, bonds, and mutual funds is difficult to gauge. This is because there is no generally accepted benchmark for measuring the performance of the nearly 6,000 hedge funds now operating around the world. Hedge funds are known to be growing in size and diversity. In practical terms, it is not easy to estimate the current size of the hedge funds industry unless all funds are regulated, or obligated to register their operations with a common authority. Brooks and Kat (2001) estimated that, as of April 2001, there are approximately 6,000 hedge funds with an estimated US$ 400 billion in assets under management and US$ 1 trillion in total assets. Three different features differentiate hedge funds from other forms of managed funds (e.g., mutual funds). Most hedge funds are small and organized around a few experienced investment professionals. In fact, more than half of the United States' hedge funds manage amounts of less than US$ 25 million. Furthermore, most hedge funds are leveraged. It is estimated that 70% of hedge funds use leverage and about 18% borrowed more than one dollar for every dollar of capital (Eichengreen and Mathieson (1998)). Another unique feature of hedge funds is their short life span. According to Lavino (2000), hedge funds have an average life span of about 3.5 years. Very few have a track record of more than 10 years. These features lead many investors to view hedge funds as "risky" and "opportunistic." But what exactly is the difference between traditional and absolute return investing? How did the hedge fund industry evolve? Which different types of hedge funds can be distinguished and what does their performance structure look like? Finally, what are the risks, returns, and pitfalls of investing in hedge funds? This paper will carefully examine these critical issues. It will introduce the reader to the basic elements of portfolio theory as well as the differences between long-only and absolute return funds. The focus lies on portraying what hedge funds are, the different types that exist, their history, and their performance structure. As mentioned before, it will also show advantages, disadvantages, and critical issues regarding hedge fund investing. II. THE DIFFERENCE BETWEEN LONG-ONLY AND ABSOLUTE RETURN FUNDS How does traditional portfolio management work? First of all, traditional long-only portfolio management can be divided into two groups: passive and active portfolio management. …