Hedge funds are supposed to generate alpha which is the excess returns that are not associated with market risk. For more sophisticated investors, alpha could be the excess return after accounting for a set of market risk factors such as the Fama-French model. The data is clear that there exists a positive gross alpha of 6-10% which suggests that holding hedge funds is a good thing even after accounting for fees. Or, at least, this is the conventional story.
A more nuanced story has arisen which is quite interesting and may change your view toward hedge funds. This story is that alpha is actually the compensation for taking downside risk from hedge funds. if you form put selling strategies against the market index, you can actually explain the alpha that is generated by hedge funds. See the paper “The cost of capital for alternative investments” by Jakub Jurek and Erik Stafford.
This is a very important paper for investors in hedge funds. It truly is a game change for portfolio construction. Hedge funds will give you higher stand-alone returns because you are being compensated for the downside risk of market extremes. This paper is clearly written but there are a lot of assumptions necessary to generate these results. The authors are very careful with how the generate there results, but everyone may not agree with the conclusions.
This result is consistent with our view of convergent and divergent trading. Many hedge fund managers are creating portfolios that generate alpha similar to put-writing because they are exploiting relative value. In essence, they are convergent traders who make money when markets are mean-reverting and prices stay away from extremes.
For investor, you have to think about the mix of hedge funds within your portfolio differently. If you are going to hold traditional hedge funds and this market extreme risk, then you should also hold those managers who will do well in market extremes. These managers would be divergent traders. This would include global macro and managed futures funds. Not all of these managers will be divergent, but it does make sense to divide the world differently than the common approach of looking for alpha producers.