The Statistical Properties of Hedge Fund Index Returns and Their Implications for Investors

The monthly return distributions of many hedge fund indices exhibit highly unusual skewness and kurtosis properties as well as first-order serial correlation. This has important consequences for investors. Although many hedge fund indices are highly attractive in mean-variance terms, this is much less the case when skewness, kurtosis and autocorrelation are taken into account. Sharpe ratios will substantially overestimate the true risk/return performance of (portfolios containing) hedge funds. Similarly, mean-variance portfolio analysis will overestimate the benefits of including hedge funds in an investment portfolio and therefore overallocate to hedge funds. We also find substantial differences between indices that aim to cover the same type of strategy. Investors9 perceptions of hedge fund performance and value added will therefore strongly depend on the indices used.