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This chapter is from the book

1.4 Hedge Fund Returns

Hedge funds are an unregulated class of investment funds that became popular beginning in the late 1990s. At the end of 2010, the hedge fund industry managed more than $2 trillion.

Figure 1.3 contains a table of returns from the years 2000 thru 2008. The first column in this table denotes the year, and the next two columns compare the returns of a broad hedge fund index published by Credit Suisse/Tremont with the Standard & Poor's 500 stock index. For example, in 2003 the Tremont index produced a return of 15.46%, while the S&P 500 index produced a return of 28.69%.

Figure 1.3

Figure 1.3 Table of hedge fund returns and stock market returns

Hedge funds charge relatively high fees compared to regulated funds, and one of the reasons they do so is their claim that the sophisticated hedging strategies they use produce returns that are insulated from stock market risk. Thus hedge funds produce positive returns whether the stock market is going up or down. Looking at Figure 1.3, we can verify this claim. During the years 2000-2002, the stock market declined a total of 38%.5 During the same time period, the hedge fund index increased by 13%. So, it would appear that the hedge fund industry's fees were very much justified.

In 2008, however, things change drastically. In this year, the stock market again dropped 38%, just like at the start of the decade. However, this time hedge funds produced a loss of 19% rather than the positive performance they produced earlier. This brings up an interesting question. What changed? Why did hedge funds produce a large negative performance in 2008 when the stock market dropped by the same amount?

The answer to this question lies in understanding the nature of the risk that hedge funds have on their balance sheets. As we show later in the book, hedge funds have considerable liquidity risk on their balance sheets, and this risk exposure is the key to explaining the performance difference of the hedge fund industry in 2008 versus the start of the decade.

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