What do we know about the risk and return characteristics of hedge funds?

Abstract

This article gives an overview of the risk and return characteristics of hedge funds. Analyzing the extensive research on hedge funds during the past two decades, this article discusses the style-specific risks of hedge funds, reviews the findings on the statistical properties of hedge funds and assesses the research on nonlinear, regime-dependent risks of hedge funds. Asset-based style factor models and regime-switching models both suggest that several (but not all) hedge fund strategies exhibit nonlinear, option-like payoffs. In recent empirical studies, financial economists argue that hedge funds are exposed to considerable credit, liquidity and bankruptcy risks in periods of stress in financial markets and that a widespread fraud problem may exist in the widely unregulated hedge fund industry.