Performance Analysis of Hedge Fonds

The goal of this chapter is twofold: First, we present an overview of the current researchon hedge fund performance. Second, we provide new evidence for the Europeanhedge fund industry. The empirical analysis scrutinizes the return patterns in thepast and alerts investors to the potential failures of conventional performance measures.Major difficulties in evaluating the performance of hedge funds are the myriad ofstrategies and the large changes of statistical measures over time. Moreover, manystrategies can be seriously hit by big losses (or gains) in the benchmark. Take mergerarbitrage as an example. MITCHELL/ PULVINO (2001) show that this strategy resemblesan uncovered short put on the market index, such that most of the times the strategyis uncorrelated with the market but large negative market returns can result inhuge losses to the investor. Unfortunately, estimating the probability of the occurrenceof such a catastrophic return is extremely hard and the characteristics of each event,like the near bankruptcy of Long Term Capital Management (LTCM) in 1998, areunique.We start out our analysis with a discussion of the return and risk characteristics ofEuropean hedge funds. In particular, we analyze their return, volatility, and correlationpattern over time. Next, we investigate whether successful funds persistently outperformtheir peers. The chapter concludes with an outline of potential failures of commonlyused performance measures.