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The Risks and Rewards of Hedge Fund Investing

There can be no doubt that hedge funds have offered very attractive returns. There are always difficulties in assessing the performance of any securities over time, whether equities, mutual funds, or hedge funds because of selection and survivorship biases which tend to overstate returns This may be especially true in the case of hedge funds, which have a less lengthy history, and much less stringent reporting requirements. In addition, many hedge funds do not report results publicly. However, looking at The VAN US hedge fund index, the longest running hedge fund index, shows an annualized 17.3% return for the 17 years ended January 1, 2005, vs. 12.4% for the S&P 500 index and 10.0% for the average Equity Mutual Fund.

 

The question that concerns new hedge fund investors most is, “Are they safe?” There is certainly a popular conception that hedge funds are highly risky and volatile investments – that they all use “global macro” strategies – making heavily leveraged bets on such things as the way currencies, interest rates, or commodities will move. The truth is that only about 5% of hedge funds are of the “global macro” variety, and most focus more on managing risk than on generating outsized returns. The best indication that hedge funds as a whole have actually been less risky than mutual funds is to look at what has happened during adverse market conditions. In the past 17 years (Since 1/88), the S&P 500 has been negative in 17 of 70 quarters. The table at the bottom lists each of these quarters, the performance of the S&P 500 index, as well as returns for the average US hedge fund and equity mutual fund.

 

The most obvious fact shown in the table is the discrepancy between average total returns between hedge funds and mutual funds over those 17 tough quarters: mutual funds on average lost 30 times more than hedge funds! What only emerges on closer inspection is that hedge funds as a group outperformed mutual funds in each and every one of those quarters! In the 53 quarters not shown, the VAN index was up in all but three (2Q94, 4Q97 and 2Q04) when it was down a nominal 0.2%, 0.1% and 1.0% respectively.

S&P 500 VAN U.S. Hedge Fund Index Morningstar Average Equity Mutual Fund
1Q90 -3.0% 2.2% -2.8%
3Q90 -13.7% -3.7% -15.4%
2Q91 -0.2% 2.3% -0.9%
1Q92 -2.5% 5.0% -0.7%
1Q94 -3.8% -0.8% -3.2%
4Q94 -0.02% -1.2% -2.6%
3Q98 -9.9% -6.1% -15.0%
3Q99 -6.2% 2.1% -3.2%
2Q00 -2.7% 0.3% -3.6%
3Q00 -1.0% 3.0% 0.6%
4Q00 -7.8% 2.4% -7.8%
1Q01 -11.9% -1.1% -12.7%
3Q01 -14.7% -3.8% -17.2%
2Q02 -13.4% -1.4% -10.7%
3Q02 -17.3% -3.6% -16.6%
TOTAL -108.1% -4.4% -111.8%

 

Performance of Hedge Funds and Mutual Funds in Down S&P 500 Quarters117 Years, 1Q1988-4Q2004
S&P 500 VAN Global Hedge Fund Index Average Equity Mutual Fund2 Average Taxable Bond Fund2
1Q90 -13.7% -5.1% -15.4% 0.6%
2Q91 -0.2% 2.4% -0.9% 1.5%
1Q92 -2.5% 5.4% -0.7% -1.1%
1Q94 -3.8% -0.8% -3.2% -2.4%
4Q94 -0.02% -2.0% -2.6% -0.2%
3Q98 -10.0% -6.9% -14.9% 2.1%
3Q99 -6.2% 1.7% -3.4% 0.2%
2Q00 -2.7% -0.7% -3.2% 0.7%
3Q00 -1.0% 2.1% 0.6% 1.6%
4Q00 -7.8% -2.3% -8.1% 1.6%
1Q01 -11.9% -0.5% -12.7% 2.6%
3Q01 -14.7% -2.7% -17.2% 1.8%
2Q02 -13.4% -1.3% -10.7% 1.3%
3Q02 -17.3% -3.3% -16.6% 1.8%
1Q03 -3.2% 0.8% -3.7% 2.2%
3Q04 -1.9% 0.6% -1.6% 2.9%
Cumulative Return -69.9% -10.6% -71.3% 17.5%
© 2005 by Van Hedge Fund Advisors International, LLC and/or its licensors, Nashville, TN, USA.1Based on data from Van Hedge Fund Advisors International

2Based on Morningstar data.

Perhaps the most common proxy used for assessing risk is the standard deviation (volatility) of returns. By this benchmark, hedge funds show less risk as well, with a standard deviation of 9.1%, compared to 15.2% for the S&P 500 and 15.7% for the average Equity Mutual Fund (See chart below).

 

U.S. and International Hedge Fund Net Returns1January 1, 1988 – December 31, 2004
Style/Strategy Net Compound Annual Return Standard Deviation Van Ratio Sharpe Ratio
Van U.S. Hedge Fund Index 17.3% 9.1% 2.9% 1.6
Van International Hedge Fund Index 14.2% 9.0% 5.8% 1.3
MSCI World Equity 6.6% 16.1% 34.1% 0.3
S&P 500 12.4% 15.2% 20.7% 0.7
Average Equity Mutual Fund 10.0% 15.7% 26.1% 0.6
© 2005 by Van Hedge Fund Advisors International, LLC and/or its licensors, Nashville, TN, USA, (615) 377-2949.1Based on data from Van Hedge Fund Advisors International