PHILADELPHIA — Imagine that you are shopping for a high performance car, but that you are not allowed to look under the hood. What's inside is a secret. Furthermore, you cannot find out how similar vehicles have performed, because there are none. Finally, the car carries no warranty.
The same logic applies to hedge funds: Investors are typically not allowed to know how they work, and no warranties are offered. Moreover, hedge-fund managers can easily "fake" high performance without getting caught.
To see how high performance can be faked, consider a fairly rare event, such as the S&P 500 falling by more than 20 percent in the coming year. Such events are commonly priced in the derivatives market, which puts the price for the S&P event at 10 cents on the dollar. An option costs 10 cents now and pays $1 if the event occurs by the end of the year, but nothing if it does not.