Finance Professor Dissects Hedge Fund Industry

“Hedge funds have been a convenient target for stereotypes,” observes Isenberg finance professor Mila Getmansky Sherman. “Our recent survey of the industry’s evolution over the past two decades* sought to dispel simplistic views by dissecting hedge funds’ considerable complexity and diversity,” she emphasizes. That is to say, she says, that hedge funds offer unique investment opportunities with more complex risk exposures than traditional investments.

Since its appearance as a National Bureau of Economic Research working paper in August, the study has received press coverage from Bloomberg News, International Business Times, and other national outlets. At Bloomberg, Getmansky Sherman, who is Associate Director of Isenberg’s Center for International Securities and Derivatives Markets, fielded questions in a seven-minute live web interview.

The authors’ wide-ranging 135-page exploration of hedge funds delves into their structure, performance, data sources, and reporting biases. It examines a wealth of hedge fund styles and devotes chapters to illiquidity and hedge fund risks and their management. And it recounts hedge funds’ role in the financial crisis of 2008.

Media Attention

Much of the study’s media exposure involved its empirically based finding that hedge fund earnings have been overstated. From 1996 to 2014, principal hedge fund tracking indexes reported mean annual returns of 12.6%. However, when Getmansky Sherman and her coauthors adjusted those returns for reporting biases, returns dropped to 6.3%. Those biases, which assume several varieties stem from the practice that, unlike mutual and other funds, hedge funds report their earnings voluntarily to the data bases that account for their performance.

Some hedge fund firms, the authors continued, wait to report their returns until they achieve positive results. That gives them the luxury of ignoring previous performance that might drag the numbers south. There’s also an “extinction bias,” where funds that underperform simply stop reporting. In 2014, the attrition rate among reporting funds reached 26% in the database studied by the authors. The authors assume that those funds either didn’t report or went extinct.

A Broader Agenda

“But make no mistake, our survey is not an argument against hedge funds,” emphasizes Getmansky Sherman. “They are essential vehicles of portfolio diversification and innovation in finance. As we noted in our paper, their freedom gives them unique breadth of coverage as an industry and unique depth of expertise among individual practitioners. And they offer us a valuable monitoring system for identifying trouble spots throughout the financial system.

“Our survey examined many investment and nonstandard risk-taking strategies involving illiquidity, nonlinearities, and operations risks,” she continues. Those and other approaches, she notes, are poorly captured by conventional metrics. “But,” she emphasizes, “more sophisticated models are available and many firms provide investors with the risk metrics to insure reliability and consumer confidence.”

Developing and testing new metrics and improved risk management techniques will continue to be a preoccupation for Getmansky Sherman, her colleagues, and the funds themselves. Meanwhile, she and her coauthors are confident that their survey will give investors, regulators, and hedge-fund managers a firm analytical handle on a dynamic, fast-evolving industry. *Hedge Funds: A Dynamic Industry in Transition. Professor Getmansky Sherman’s coauthors are MIT Sloan professor Andrew Lo and Peter Lee of the AlphaSimplex Group in Cambridge. Professor Lo was principal presenter at Isenberg’s annual CISDM conference in October of 2014. (The Isenberg center studies alternative investments and maintains a leading hedge fund data base.)

*The report is available from SSRN here.