Hedge Funds: An Industry in Its Adolescence

William K.H. Fung and David A. Hsieh
Economic Review, Vol. 91, No. 4, 2006

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The dramatic increase in the number of hedge funds and the "institutionalization" of the industry over the past decade have spurred rigorous research into hedge fund performance. This research has tended to uncover more questions than answers about the dynamic and multifaceted hedge fund industry.

This article presents a simple hedge fund business model in which fund returns are a function of three key elements—how the funds trade, where they trade, and how the positions are financed. The article also provides methods to help investors, intermediaries, and regulators identify systemic risk factors inherent in hedge fund strategies.

Estimating these risk factors requires having an accurate history of hedge fund performance. The authors examine recent statistics from three commercial hedge fund databases and discuss the problems with database biases that must be recognized to obtain accurate measures of returns.

While the data show that today's hedge funds use myriad strategies that have no uniform definition, the proposed business model implies that hedge fund managers are diversifying in order to maximize the enterprise value of their firms. But this diversification does not preclude the risk of leveraged opinions converging onto the same set of bets. Preventing convergence risk will require action by investors, intermediaries, regulators, and fund managers to improve industry-level disclosure and transparency while preserving the privacy of individual hedge funds' positions.

December 2006