Higher risk, lower returns: What hedge fund investors really earn

The returns of hedge fund investors depend not only on the returns of the funds they hold but also on the timing and magnitude of their capital flows in and out of these funds. We use dollar-weighted returns (a form of Internal Rate of Return (IRR)) to assess the properties of actual investor returns on hedge funds and compare them to buy-and-hold fund returns. Our main finding is that annualized dollar-weighted returns are on the magnitude of 3% to 7% lower than corresponding buy-and-hold fund returns. Using factor models of risk and the estimated dollar-weighted performance gap, we find that the real alpha of hedge fund investors is close to zero. In absolute terms, dollar-weighted returns are reliably lower than the return on the Standard & Poor's (S&P) 500 index, and are only marginally higher than the risk-free rate as of the end of 2008. The combined impression from these results is that the return experience of hedge fund investors is much worse than previously thought. (C) 2011 Elsevier B.V. All rights reserved.