Testing the Hypothesis “Hedge Fund Performance Is Good”

Abstract

The article introduces a possible solution to the problem of evaluating the performance of long-short equity hedge funds. While peer groups and indexes do not work for a variety of reasons, a modern-day application of classical statistics does work. Taking the view that performance evaluation is a hypothesis test, where the hypothesis is “performance is good”, the article recommends comparing what could have happened with what actually happened. Portfolio simulations create random portfolios that conform to an individual manager's approach, thereby customizing performance evaluation to each manager. This simulation technology is not new or hypothetical. It has been used to evaluate traditional long-only managers for more than a decade and has recently been extended to hedge funds. Examples are provided that show how hedge funds are evaluated using portfolio simulations as the backdrop.