On the Performance of Hedge Funds

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Abstract
Empirical evidence indicates that hedge funds differ substantially from traditional investment vehicles, such as mutual funds. Unlike mutual funds, hedge funds follow dynamic trading strategies and have low systematic risk. Hedge funds' special fee structures apparently align managers' incentives with fund performance. Funds with “high watermarks” (under which managers are required to make up previous losses before receiving any incentive fees) significantly outperform those without. Hedge funds provide higher Sharpe ratios than mutual funds, and their performance in the period of January 1992 through December 1996 reflects better manager skills, although hedge fund returns are more volatile. Average hedge fund returns are related positively to incentive fees, fund assets, and the lockup period.