An Evaluation of Hedge Funds: Risk, Return and Pitfalls
Abstract
Hedge funds are collective investment vehicles fast becoming popular with high net worth individuals as well as institutional investors. These are funds that are often established with a special legal status that allows their investment managers a free hand to use derivatives, short sell and exploit leverage to raise returns and cushion risk. Given that they have substantial latitude to invest, it is instructive to examine the performance of hedge funds as compared to other forms of managed funds. This paper provides an overview of hedge funds and discusses their empirical risk and return profiles. It also poses some concerns regarding the empirical measurements. Given the complexity of hedge fund investments, meaningful analytical methods are required to provide greater risk transparency and performance reporting. Hedge fund performance is also beset by a number of practical issues generating practical risks. These risks are not fully addressed by the usual riskadjusted performance measures in the literature. A penalty function to discount these extraneous risk dimensions is proposed. The paper concludes that further empirical work is required to provide informative statistics about the risk and return of hedge funds.