Do hedge fund investors actually receive the returns reported for hedge funds, or does the timing of investments in these funds substantially affect experienced returns? In the March 2009 version of their paper entitled "Higher Risk, Lower Returns: What Hedge Fund Investors Really Earn", Ilia Dichev and Gwen Yu measure actual hedge fund investor returns by integrating the returns of the funds they hold with the timing and magnitude of their capital flows into and out of these funds. Specifically, they calculate an aggregate internal rate of return (dollar-weighted return) that treats funds as time-ordered investor capital flows, with initial fund market value and fund inflows counted as negative flows and fund outflows and ending market value counted as positive flows. Using monthly net-of-fee return and assets under management data for a large sample of hedge funds over the period 1980-2006, they conclude that:
- The preponderance of the increase in hedge fund assets under management over the sample period comes from capital inflows and not organic fund growth. In general, an influx of capital signals poor future returns for a hedge fund, due primarily to diminishing marginal benefits from incremental investments.
- The aggregate annualized dollar-weighted return from hedge funds to investors is on average about 4% less than the comparable passive buy-and-hold hedge fund return (compared to 1.5% deficits between dollar-weighted returns for broad stock indexes and mutual funds relative to buy-and-hold).
- Dollar-weighted underperformance of buy-and-hold is most pronounced (8-9%) for hedge funds with high returns and high volatilities of capital flows.
- Dollar-weighted hedge returns are reliably below comparable returns for broad-based stock indexes.
- Dollar-weighted hedge fund returns are more variable (standard deviation of annual returns 19.9%) than buy-and-hold hedge fund returns (standard deviation of annual returns 15.5%).
In summary, actual hedge fund investor return/risk experience, due to the timing of entries and exits, is much worse than that indicated by the continuously measured returns and volatilities of the funds themselves.
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