LO 71.4: Evaluate the role of investors in shaping the hedge fund industry.

LO 71.4: Evaluate the role of investors in shaping the hedge fund industry.
Historical data on hedge fund performance was difficult to obtain prior to the early 1990s. In early 1994, dramatic losses triggered by a Federal Reserve change in interest rate policy had a large impact on hedge fund performance reporting. This prompted the development of hedge fund databases so that participants could better obtain and analyze hedge fund performance.
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Topic 71 Cross Reference to GARP Assigned Reading – Constantinides, Harris, and Stulz, Chapter 17
Assets under management have increased 10 times from 1997 to 2010 as the number of funds has quadrupled. There are some hedge funds that do not participate in commercial databases, which impacts aggregate hedge fund performance. Thus, there is selection bias, also known as self-reporting bias, contained in hedge fund databases.
There is evidence that suggests that selection bias in large hedge fund databases is actually small. The average return of funds-of-hedge funds (FOHF), comprised of managers who theoretically invest across all hedge funds, not just funds reported to commercial databases, is highly correlated to the average return of hedge funds in commercial databases.
However, there are still concerns about possible measurement errors and various biases in reported hedge fund returns. The consensus is that hedge fund index returns became increasingly reliable beginning in 1996. Prior to 1996, looking at the period from 1987 to 1996, 27 large hedge funds substantially outperformed the S&P 500 index. The outperformance is high, which is more than enough to account for any measurement biases.
The collapse of Long-Term Capital Management (LTCM) in 1998 was a watershed event in the hedge fund industry. It was a reminder that higher returns are accompanied by higher risk. The LTCM collapse had a much greater effect on hedge fund performance compared to equity performance.
The time period of 2000 to 2001 brought the dot-com bubble collapse. During this period, the hedge fund industry experienced a 20% net asset inflow and there was a major shift in the hedge fund industry structure. Hedge funds outperformed the S&P 500 with half of the S&P 500 standard deviation. As a result, institutional investors poured money into hedge funds.
>From 1999 to 2007, hedge funds assets under management went from $197 billion to $1.39 trillion. Investors in hedge funds thus shifted from exclusively private wealth to institutions, including foundations, endowments, pension funds, and insurance companies. Evidence suggests that these institutional investors were rewarded from 2002 to 2010 with high returns, due in large part to bearing credit and emerging market risks.
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