Several studies that look at the long-term returns of hedge funds conclude that they outperform benchmarks based on broad stock market and bond index figures. For example, a KPMG study found that hedge funds generated a 9% average annual return between 1994 and 2011. The study also points to the diversification benefits of investing in hedge funds, since the correlation between hedge fund returns and stocks and bonds was very low.

However, several empirical studies show that hedge funds tended to underperform more traditional investment strategies (combinations of stock and bonds) in recent years. The main message is that average hedge fund returns were higher in the earlier years of the existence of the industry, when the number of assets under management (AUM) was much smaller than today. For example, during the period 19942011 in the KPMG study above, it was good returns in the years 19948, when the average was 12%, that led to an overall average annual return of 9%. From 2007 to 2011, annual returns averaged only 2%. Where hedge funds provided high returns that were uncorrelated with the rest of the market in 20002 after the dotcom bubble burst, relative hedge fund returns disappointed in 2008 after the financial crisis. In this period, hedge fund returns were uncorrelated with the rest of the market and they did not outperform. Other similar findings of disappointing hedge fund returns in recent years include research from the Vanguard Group, showing that a simple 60/40 portfolio beat the returns of the hedge-fund industry in aggregate.

HFR, a firm that track hedge-fund performance, reported that the average hedge fund provided 3% gains in 2014, compared to 11% return from the Standard & Poor's 500 Index. Furthermore, it is likely that the HFR return figures overstate hedge fund returns because hedge funds have no obligation to report their performance and underperforming hedge funds are typically excluded from the annual survey. Fees charged by hedge fund managers and the impact thereof on net investor returns have also been a controversial issue for some time. For example, a large Dutch pension fund stated in a press release in late 2014 that hedge funds fees represent a disproportionately large part of total fees hedge funds only make up about 2% of their assets under management, but account for 32% of all investment fees.

When evaluating the long term relative performance of hedge funds, the return measure used is also a big issue. Typically, the average annual return or time-weighted return of hedge funds is used to evaluate relative long-term performance. Time-weighted returns do not take any contributions or withdrawals from an investment into account, while dollar-weighted returns do take the amounts added or withdrawn from the investments into account. Time-weighted returns are the most common method used to measure and evaluate the relative performance of mutual funds and hedge funds, because investment withdrawals and amounts added to the fund are not under the control of the fund manager. However, in the case of the hedge fund industry, it can be argued that using dollar-weighted returns gives a better indication of the returns experienced by actual hedge fund investors than using time-weighted returns. This is because the hedge fund industry experienced high returns during times when the industry was new and the number of assets under management (AUM) was relatively low, and lower returns in later times when the number of AUM was higher. The study of Dichev and Yu, published in 2011, illustrates the difference between using time-weighted and dollar-weighted returns in evaluating the long-term performance of hedge funds. Their results indicate that the time-weighted return on hedge funds for the 19802008 period was 11.0% per annum, while the dollar-weighted return was only 4.1% per annum.

In this case study, it is argued that time-weighted returns might provide a more appropriate and realistic indication of the returns earned by the average hedge fund investor. Do you agree with this viewpoint? Explain your answer.