LO 70.5: Explain the difficulties in measuring the performance of hedge funds.

LO 70.5: Explain the difficulties in measuring the performance of hedge funds.
Long-short hedge funds are often used to complement an investors well-diversified portfolio. For example, the investor might allocate funds to a passively managed index fund and an actively managed long-short hedge fund. The hedge fund is designed to provide positive alpha with zero beta to the investors overall composite portfolio. The hedge fund creates portable alpha in the sense that the alpha does not depend on the performance of the broad market and can be ported to any existing portfolio. Because the long-short fund is market-neutral, the alpha may be generated outside the investors desired asset class mix.
Unfortunately, hedge fund performance evaluation is complicated because:
Fledge fund risk is not constant over time (nonlinear risk). Hedge fund holdings are often illiquid (data smoothing). Hedge fund sensitivity with traditional markets increases in times of a market crisis and
decreases in times of market strength.
The latter problem necessitates the use of estimated prices for hedge fund holdings. The values of the hedge funds, therefore, are not transactions-based. The estimation process unduly smoothes the hedge fund values, inducing serial correlation into any statistical examination of the data.
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