With the growth of hedge funds in recent years, it is good that Ibbotson and Chen investigate whether these funds actually do as well as they often claim. And the answer? They do well, but not as well as claimed.
Some of the more serious problems in studying hedge funds are data related. Specifically, survivorship bias and the related backfilling of data lead to a bias in reported returns. Ibbotson and Chen investigate these problems using their data from 1995 to 2004 and as expected find that the problem is quite severe especially in smaller funds.
"The equally weighted performance of the funds that existed at the end of the sample period had a compound annual return of 16.64% net fees. Including dead funds reduced this return to 13.90%. Excluding backfill further reduced the return to 9.06%, net of fees."So the returns are lower than many believed. That does not mean that the returns are not good relative to other investments. The authors therefore try to break this return down to determine "the average amount of hedge fund returns that come from long-term beta exposures versus the hedge fund value-added alpha."
They find that alphas are positive and significant:
"Note that the index of all the funds has an annual compound return of 9.1% over the period. This return was not as high as the S&P 500 return of 12.2%, but given the low betas on stocks (0.33) and bonds (Â0.30), with a beta on cash of almost one (0.97), the alpha was a high 3.7% and statistically significant at the 5% level. Most catergories have low RSQs as well."
Interestingly, this alpha (which can be seen as abnormal return), is split almost evenly between fees to the fund and returns to the investors:
While the returns may not be as high as reported, they are still better than would be expected in a perfectly efficient market and the returns are not highly correlated with broader marketindicess.
In the author's words:
"Thus, our results confirm that hedge funds added alpha over the period, and also provided excellent diversification benefits to stock, bond, and cash portfolios."
Which might just explain some of their popularity ;)Definitely another of those I^3 papers!
Ibbotson, Roger G. and Chen, Peng, "Sources of Hedge Fund Returns: Alphas, Betas, and Costs" (June 2005). Yale ICF Working Paper No. 05-17. http://ssrn.com/abstract=733264