Investing in Hedge Funds: Risks, Returns and Pitfalls

Ferrell Focus Working Paper

29 Pages Posted: 25 Jun 2002  

Francis Koh

Singapore Management University - Lee Kong Chian School of Business

David K.C. Lee

Ferrell Asset Management; Sim Kee Boon Institute for Financial Economics; Visiting Fellow; Practice Professor of Quantitative Finance

Kok Fai Phoon

Ferrell Asset Management

Date Written: May 2002

Abstract

Hedge funds are collective investment vehicles fast becoming popular with high net worth individuals as well as institutional investors. These are funds that are often established with a special legal status that allows their investment managers a free hand to use derivatives, short sell, and exploit leverage to raise returns and cushion risk. Given that that they have substantial latitude to invest, it is instructive to examine the performance of hedge funds compared to other forms of managed funds. This paper provides an overview of hedge funds and discusses their empirical risk and return profiles. It also poses some concerns regarding the empirical measurements. Given the complexity of hedge fund investments, meaningful analytical methods are required to provide greater risk transparency and performance reporting. Hedge fund performance is also beset by a number of practical issues generating "practical risks". These risks are not fully addressed by the usual risk-adjusted performance measures in the literature. A penalty function to discount these extraneous risk dimensions is proposed. The paper concludes that further empirical work is required to provide informative statistics about the risk and return of hedge funds.

Keywords: hedge funds, performance measurement, risks and returns, Sortino, Hurst, risk-adjusted measures

JEL Classification: G0

Suggested Citation

Koh, Francis and Lee, David K.C. and Phoon, Kok Fai, Investing in Hedge Funds: Risks, Returns and Pitfalls (May 2002). Ferrell Focus Working Paper. Available at SSRN: https://ssrn.com/abstract=314539 or http://dx.doi.org/10.2139/ssrn.314539

Francis Koh

Singapore Management University - Lee Kong Chian School of Business ( email )

469 Bukit Timah Road
Federal Building #02-05
Singapore 912409
Singapore

David K.C. Lee

Ferrell Asset Management ( email )

Singapore
65-65366623 (Phone)

Sim Kee Boon Institute for Financial Economics ( email )

90 Stamford Road, 6th Level
School of Economics
Singapore, 178903
Singapore

Visiting Fellow ( email )

Stanford, CA 94305
United States

Practice Professor of Quantitative Finance ( email )

Li Ka Shing Library
70 Stamford Road
Singapore 178901, 178899
Singapore

Kok Fai Phoon (Contact Author)

Ferrell Asset Management ( email )

80 Raffles Place #28-21
UOB Plaza 2
Singapore 048624
Singapore

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