Investible Benchmarks and Hedge Fund Liquidity

Abstract

A lack of commonly accepted benchmarks for hedge fund performance has permitted hedge fund managers to attribute to skill those returns that may actually accrue from market risk factors and illiquidity. Recent innovations in hedge fund replication permit us to estimate the extent of this misattribution. Using an option-based model, we find evidence that hedge fund returns in excess of a benchmark may not even compensate investors for liquidity options they grant to managers when they accept restrictions on their right to redeem their investments. Coupled with the competition from hedge fund replication vehicles, this analysis may motivate hedge fund investors to demand relaxed redemption terms from hedge fund managers.

TOPICS: Real assets/alternative investments/private equity, performance measurement