Chapter 16. Hedge Funds

This chapter begins with a brief history of hedge funds from the perspective of hedge fund investors—exploring the attributes that attracted private, wealthy investors to an opaque, nascent hedge fund industry during the decades leading up to new millennium. Following the chronology of several important market events, the first two sections traces the performance of hedge funds from these early days of the industry to the recent decade during which institutional investor emerged as the dominant investor group—a phenomenon that began shortly after the burst of the dot-com bubble and survives to this date. The arrival of institutional investors did much to encourage more transparency on the way hedge funds operate and spurred the development of performance benchmarks and databases. Using these benchmarks of hedge funds section two assesses the risk-adjusted performance of hedge funds during these decades of changing investor clientele. An important attraction of the hedge fund industry to portfolio investors is the rich tapestry of strategies with widely divergent risk-return characteristics. Section 3 is devoted to models of different categories of hedge fund strategies and highlights the drivers of performance as well as their inherent risk factors. Armed with these analytical tools and the empirical evidence on the capital formation process since the turn of the century, section 4 begins by tackling the problem of portfolio construction. The section continues with a reminder on the impact of leverage inherent in most hedge fund strategies and argues that risk management must take into account both dimensions of risk—those that emanates from holding risky assets as well as attendant risk of funding leveraged positions. The chapter concludes with discussions the impact of hedge fund research on product innovations, risk management of leverage hedge fund products and performance evaluation.