Hedge Fund Manager Selection is an act of Faith

Summary
Several of my posts over the years have highlighted evidence that manager selection does not add value to investment portfolios.  (See "Manager Selection is a Hail Mary Pass” https://www.empoweringinvestors.com/the-zask-blog/hedge-fund-manager-selection-is-a-hail-mary-pass). 

Most investment consultants and investment managers claim to add value to investors by selecting fund managers that deliver superior performance relative to their benchmarks and peer group. However, despite the importance of manager selection, the evidence indicates that choosing superior managers is extremely difficult in the face of obstacles including the wide dispersion of hedge fund performance compared to the stock market, and performance of hedge funds is plagued by the lack of sustainability of superior results over multiple time periods. It turns out the warning that “past results are not indicative of future performance” is exactly right.  However, rather than confronting this contradiction, most investment manager ignore the evidence and offer the narrative that their investment process does allow them to pick superior managers.

Importance of Manager Selection to Investment Returns
David Swensen, the Chief Investment Officer of the Yale Endowment, has been very influential in the investment committee. The endowment’s strategy, known as the “Yale Model” has been imitated by many investors around the world. However, what is often overlooked is the critical task of selecting and being able to invest in the best performing managers.  The Yale Model has the following features:

• Multi-asset class diversification with large allocations to alternative asset classes resulting in an efficient portfolio with several potential sources of return.
• High allocation to illiquid asset classes to harvest the illiquidity premium and exploit the greater potential for alpha in private markets.
• Avoiding market timing.
• Rigorous due diligence to identify and select the best asset managers
• Maintaining relationships that allow Yale to gain access to top-tier funds that be closed to other investors.

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And yet, selecting a top-tier investment manager is hindered by the wide dispersion of hedge fund returns and the lack of sustainability of hedge fund performance.

Dispersion of Hedge Fund Returns
As shown below the dispersion of hedge fund returns is much wider than for stocks and bonds. This is true even for equity hedge funds, which have a lower volatility but a much wider dispersion that stocks. The implication is that the difference in performance between top-tier and low-tier funds is much wider for hedge funds than for stocks, making the hedge fund selection more difficult and more important to the overall success of an investment.

The wide dispersion also limits the usefulness of hedge fund indices that present the average return of thousands of hedge funds. The index number provides virtually no information about the underlying universe of funds.
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Hitting a Moving Target: Lack of Persistence in Hedge Fund Performance
Investment consultants need to select funds whose top-tier ranking is persistent over time. However, numerous studies of different investment vehicles find that persistence in tier positions is does not hold.  The fact that a fund is in the top decile provides no predictive power of its placement in the future.
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For example, a Goldman Sachs article, “The Case for Hedge Funds,” finds that a fund’s performance ranking in one period provides very little information about its ranking in subsequent periods.  In other words, choosing funds based on their past performance is effectively a random process. A Goldman Sachs report states the following:

The assumption that the strong performers of the past will remain at the    head of their pack in the future has historically been a mistake, precluding this approach as the primary means to vet managers. For example, looking at data over the period 1990–2012, only 21% of first-quartile performers in one year remained first-quartile performers in the next, as shown below. Conversely, 23% of bottom-quartile performers made the top quartile the next year. (See Below)
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Ignoring the Evidence and Taking A Leap of Faith 
Reaping the benefits of hedge funds is extremely difficult given their wide dispersion and lack of persistence, yet manager selection is the key to gaining the benefits of hedge funds.  How do investors and their advisors reconcile this contradiction?

Essentially, most managers ignore the evidence, and claim that their methodology allows them to pick winning funds. An example is provided by Goldman Sachs’ report as it attempts to reconcile the report’s rosy picture of hedge fund benefits with the problems of identifying top performing managers:

“Manager selection begins with sourcing. … Quality sourcing is often dependent on the breadth and depth of the relationships an investor has established with managers, with clients, and in the market generally…Once an opportunity is identified, a robust evaluation process must ensue. This process should be repeatable and scalable, and evolve over time…In many ways, due diligence is a search for a consistent story across all areas of a manager.”

This is not exactly a precise formula for choosing top tier hedge funds. Yet this description, which is representative of the industry’s narrative, effectively kicks the ball down the field in the hopes that a vague “manager selection” process will make up for the dispersion of and lack of persistence in manager results.

Pulling it Together: Studies of the Difficulty of Successful Fund Selection
In a series of studies released by the Pensions Institute, a U.K. group, provided alarming evidence of the inability of managers to select funds that outperform. [Although these studies were based on U.K. mutual funds, there is considerable evidence that similar conclusions apply to U.S. funds.] The studies examined 516 UK equity funds between 1998 and 2008 and found that only 1% of managers were able to return more than the trading and operating costs they incurred. Further, these managers pocketed for themselves most of the value they added in fees, leaving little or nothing for the investor. [This conclusion parallels the excellent analysis conducted by Simon Lack in The Hedge Fund Mirage.]

Star managers are, to quote the report, “incredibly hard to identify”.  It takes 22 years of performance data to be 90% sure that a manager’s outperformance is genuinely down to skill.  This parallels an earlier study conducted by Barra which found that it takes 18 years to identify outperformance resulting from manager skill among U.S. mutual funds.]
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Perhaps the most alarming finding of the Pensions Institute study was that not only were the vast majority of managers unlucky (i.e., their results could be explained by random chance), but they were “genuinely unskilled” in that their performance was even worse than predicted by random chance.

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