Hedge funds
A few highly successful managers over the past two decades have brought attention to the small but interesting class of investment vehicles known as hedge funds. The largest of these, the multibillion dollar Quantum Fund managed by George Soros, boasts compounded annual returns exceeding 30% for more than two decades. These superior returns have attracted both institutional and private investors. Hedge funds are similar to mutual funds in that they are actively managed investment portfolios holding positions in publically traded securities. Unlike mutual funds, they have broad flexibility in the types of securities they hold and the types of positions they take. In addition, they can invest in international and domestic equities and debt, and the entire array of traded derivative securities. They may take undiversified positions, sell short and lever up the portfolio. A recent study of hedge funds by Fung and Hsieh (1997) shows how dramatically hedge fund strategies differ from those of open-end equity mutual fund managers. Their application of
Sharpe’s (1992) style analysis to a sample of monthly hedge fund returns reveals that hedge funds actively shift their factor exposures, and this dynamic activity makes performance measurement difficult. Despite the problems of performance measurement, the most interesting feature of hedge funds is that they are thought of as nearly pure “bets” on manager skill. These funds were conceived as market-neutral investment vehicles that pursued strategies akin to “arbitrage in expectations.”1
Hedge fund managers seek out and exploit mis-pricing of securities using a variety of financial instruments. They produce superior performance, and they are not judged by their ability to track a passive benchmark. As a result, the compensation structure within the industry is based largely on performance. Compensation terms typically include a minimum