Do hedge funds add value to a passive portfolio? Correcting for non-normal returns and disappearing funds

Abstract

Hedge funds have greatly increased their assets under management in the last decades, partly driven by investments from institutions such as pension funds and endowments funds. This paper considers the added value of an investment in hedge funds from the perspective of a passive investor. The Zurich Hedge Fund Universe is used for the empirical investigation, over the period 1995–2000. The database includes a large number of funds that have disappeared over the years, which reduces the impact of survivorship bias. It is found that hedge fund alphas are positive, even after correcting for the non-normality of the hedge fund return distribution. Over longer periods, however, the added value of hedge funds is severely hampered by the large number of funds disappearing from the database, usually after poor performance. Investors can avoid some of the disappearing and bad performing funds by requiring a track record of good performance.