HEDGE FUND MYTHS

As mentioned earlier, the public perceives hedge funds as risky investments
appropriate for thrill-seeking investors. This myth and others persist despite
evidence to the contrary.
Hedge funds are sometimes called absolute return strategies. The
idea of absolute return is in contrast to traditional money management,
where returns are compared to a benchmark of returns on similar assets.
The return on a portfolio of stocks is compared to the S&P 500 or other
index, and a manager is judged not on whether the portfolio was profitable
but rather on how the portfolio return compared to the market return.
In contrast, absolute return strategies can be expected to be
profitable regardless of what happens to any identifiable index. In theory,
the absolute return manager would be judged only on the size and
consistency of returns.
However, most hedge funds retain at least some correlation to stock
and bond returns. Academic studies have shown that the returns on
hedge funds can at least in part be explained by market returns and
other economic factors (credit spreads, volatility, and others). Further,
for hedge funds that follow a popular strategy, it is possible to benchmark
an individual fund’s return against peer fund returns. Finally,
hedge fund indexes now exist that provide reasonable benchmarks for
many hedge funds.
Another hedge fund myth involves assumptions about the life cycle of
hedge funds. Many investors refuse to invest in hedge funds that have less
than, for example, two years of performance in the belief that young funds
are more likely to fail. Other investors seek to invest in young funds because
they believe that smaller, newer hedge funds provide higher returns
than large funds that have been in existence for many years. In addition,
there is a belief that hedge funds don’t tend to survive longer than about
eight years.

In fact, many factors affect the riskiness of hedge funds, the return to
particular funds, and the popularity of an investment style. Certain strategies
such as convertible bond arbitrage remain attractive, despite existing
for decades. The early demise of many new hedge funds can be explained
by weaknesses in investment strategy, failure to establish systems and operating
procedures, or simply bad timing for a fund of a particular style or
strategy.