Higher Risk, Lower Returns: What Hedge Fund Investors Really Earn

Abstract:     
This study makes a critical distinction between the returns of hedge funds and the returns of investors in these funds. Investor returns depend not only on the returns of the funds they hold but also on the timing and magnitude of their capital flows into and out of these funds. The capital flow effect exists for any investment but is especially relevant for hedge funds because of the large magnitude and variation in the associated capital flows. We use dollar-weighted returns (a form of IRR) to assess the properties of actual investor returns on hedge funds and compare them to buy-and-hold fund returns. Our first finding is that annualized dollar-weighted returns are on average about 4 percent lower than corresponding buy-and-hold fund returns. This performance gap rises to as much as 9 percent for “star” funds with the highest buy-and-hold returns and for funds with high volatility of capital flows, a remarkable difference in assessing long-run investment performance. In addition, dollar-weighted returns are below comparable returns for broad-based stock indexes. Our second finding is that dollar-weighted returns are more variable than their buy-and-hold counterparts. The combined impression from these results is that the return experience of hedge fund investors is much worse than previously thought.

Keywords: Hedge fund, Investor capital flows, Dollar-weighting

JEL Classifications: G11, G23, G31

Working Paper Series