Hedge Fund Performance During and After the Financial Crisis

According to Capital Market Theory, the Market Portfolio – made up of all the assets in the market – is the most mean-variance-efficient portfolio and investors make up their own portfolios, according to their appetite for risk, through investing more or less amounts in the Market Portfolio, with borrowing or lending. Such investment styles are known as passive. Real markets are not efficient, many imperfections exist, such as taxes, dealing charges; information is not simultaneously available to all participants, investors do not have homogeneous expectations and all assets are not equally scrutinised. Investment styles which exploit market imperfections and the opportunities therefrom, via mispriced assets, are classified as active, in contrast to the passive style.

Hedge funds have rapidly evolved as investment vehicles for active strategies, and are much sought after by investors, either for investment in themselves or as part of a portfolio. They were first created in 1949 and represent an alternative asset class that is closely related to mutual funds but exhibit some major differences. Hedge funds are not regulated as strictly as mutual funds which gives them the possibility to invest in traditional, as well as, alternative and more risky securities and derivatives. Furthermore, hedge funds are eligible for short-selling and leverage.

Another important characteristic of a hedge fund is that they generally invest in less liquid assets, compared to mutual funds. This can be done by generating "lockup periods" for investors. During these specified periods investors cannot redeem their investment. As a result of the specific characteristics and a high minimum investment (usually between US$500,000 and US$1million), access to hedge funds is limited to sophisticated investors, such as institutions or wealthy individual investors. Nowadays, hedge fund assets can vary from traditional products, such as equities, bonds, real estate to alternative assets, such as paintings, artefacts, antiques, and other exoticities.

The hedge fund industry has been growing rapidly – from only US$118 billion in 1997 to over US$3 trillion in 2016. Many economies faced a crisis in 2007–2009, in the aftermath of the sub-prime mortgage market crash. Between 2007 and 2008, the beginning of the financial crisis, assets under management by hedge funds, worldwide, dropped by 25%, when many funds had to close. As hedging has the meaning of adopting a strategy to reduce risk, it becomes meaningful to analyse the performances of hedge funds, during and after the crisis.

The aim of this research is, thus, to gain a deeper understanding of the risk-adjusted performance of major hedge fund strategies in different market conditions and then to ascertain which risk frameworks are most reliable for evaluating performance. To the best of our knowledge, such a study covering the last ten years has not been published.

To achieve the aim of this research, a literature review is first conducted in Section 2. The literature review covers a broad overview of hedge funds and their major strategies; this is followed by a summary of empirical research on hedge funds, a critical discussion of performance measurement models, persistence in performance, and alternative reward risk ratios. In Section 3, the methodology, data accessed and other relevant issues to this research are described. In Section 4, the, monthly performance data of ten major hedge fund strategies from 2007 to 2017 is analysed from various perspectives, with the S and P 500 as the market benchmark. Correlations of the different strategies with the entire market, and the results of Carhart's four factor model are studied. Persistence in performance is tested statistically and the reward-risk characteristics of the various hedge fund strategies are analysed in different periods, within traditional and downside risk frameworks. The findings are also discussed in this section. Finally, Section 5 concludes the paper and gives some ideas for further research on this topic.