“…Many hedge funds seek to profit in all kinds of markets by pursuing leveraging and other speculative investment practices that may increase the risk of investment loss.” – SEC, Hedging your bets: a heads up on hedge funds and funds of hedge funds.
“A hedge fund is an actively managed investment fund that seeks attractive absolute return…. Hedge fund managers are active managers seeking absolute return.” – Robert A. Jaegar, All About Hedge Funds (2003)
“Hedge funds are alternative investments using pooled funds that may use a number of different strategies in order to earn active return, or alpha, for their investors.” – Investopedia
To summarize, the ultimate purpose of hedge fund is to earn attractive return, preferably seeking positive alpha and that’s how the hedge fund managers market their fund – making positive alpha. But are the funds serving this purpose? Do they really make above market returns every year? Have these funds been able to beat the market in the long term, say 5 years, 10 years?
To come up with an answer requires some study since hedge funds are mostly limited partnership and free from all the regulation that mutual funds are subject to, Hence there is limited information about the short/long term performance of the funds.
Morningstar Broad Hedge Fund, which encompasses more than 500 hedge funds serves as a useful index for benchmarking and is also a good estimate of performance of hedge funds. Based on annual return starting 2009 through 2014, the historical rate of return for this index has been 4.3%. At the same time, it has been 10.5% for S&P 500.
(Data extracted from Morningstar)
Even when individual years are compared, hedge funds have been able to beat S&P 500 only 2 out of 6 times. So even though investing in the market seems a viable investment compared to hedge fund, still hedge funds are popular and attract investments from accredited investors. The popularity for hedge funds can be associated to these causes: Gains are announced. Out of the many existing hedge funds, there are few standout firms that are earning substantial returns, sometimes even during market turmoil. These are the funds that get media coverages, thereby garnering attention. On the other side, limited regulatory requirement means limited disclosure of information i.e. no need to publicize losses. A decent bet. Hedge fund are essentially a good lottery to bet on. Since its open only for accredited investors, they won’t feel as much financial pain as would a non-accredited investor. On the up side, you have better chance in winning in a hedge fund than in winning a lottery ticket.
In essence, hedge funds do not serve the purpose they are supposed to serve. However, given the limitation of data, it is necessary to further assess this scenario with sufficient data to support this conclusion.