What Hedge Fund Investors Really Earn

On the whole, hedge funds don't provide returns worth the risk and costs involved with investing in them. Now, a new study shows that hedge-fund investors actually underperform the very hedge funds in which they invest.

As we discussed earlier, hedge funds have several characteristics that make them undesirable investment vehicles for prudent investors. Also, hedge funds have not demonstrated outperformance over other asset classes. Still, some investors are lured by the hope of picking the right hedge fund and earning great returns, even after the high costs associated with such an investment.

Ilia Dichev and Gwen Yu, of the University of Michigan, studied the dollar-weighted returns of hedge funds in their paper "Higher Risk, Lower Returns: What Hedge Fund Investors Really Earn." Dollar-weighted returns measure not only the returns of the fund, but also the capital flows in and out of these funds. This measure shows when investors are jumping in or getting out, and demonstrates the returns these investors actually earn while invested in the fund.

Dichev and Yu found that:

• Annualized dollar-weighted returns were about four percent lower than buy-and-hold returns.
• The gap rose to as much as nine percent for the funds with the highest buy-and-hold returns.
• The dollar-weighted returns were lower than comparable returns for broad-based stock indexes.
• Dollar-weighted returns of hedge funds were also more variable than buy-and-hold returns.

Hedge funds operate in highly competitive markets, where information and trading advantage are unlikely to be maintained for long. As hedge funds themselves proliferate and grow, deploying larger amounts of capital becomes progressively more difficult and chasing the same investment opportunities yields diminishing returns.