Chapter 8 - Hedge fund investing: Some words of caution

Abstract

It is almost a fact now that hedge funds are a lot more complicated than common stocks and bonds and may not be as phenomenally attractive as many hedge fund managers and marketers want investors to believe. This chapter reviews some of the most important findings so far. From this, it becomes clear that hedge fund investing requires a much more elaborate approach than what most stock and bond investors are used to. Mechanically applying the same decision making processes as typically used for stock and bond investing may lead to nasty surprises. The available data on hedge funds should be corrected for various types of errors, survivorship and backfill bias, and autocorrelation. Tools like mean-variance analysis and the Sharpe ratio are no longer appropriate when hedge funds are involved. Including hedge funds in a traditional investment portfolio can significantly improve that portfolio's mean-variance characteristics, but it can also be expected to lead to significantly lower skewness as well as higher kurtosis. This means that the case for hedge funds is a lot less straightforward than suggested and requires investors to make a definite tradeoff between profit and loss potential.