Hedge Fund Performance Panned by Academic Research

FEBRUARY 28, 2016
The performance of hedge funds is one of the most written about topic in the financial media.  Headlines herald each week's performance -- i.e.; Hedge Funds beat Stocks last week -- as if the information is actually useful for investors or conveys any truths about hedge fund performance. The topic of hedge fund performance is dominated by hedge funds themselves, their industry groups, and the "service providers" who depend on hedge funds for access and information.  It is therefore no wonder that it is heavily skewed towards showing hedge fund performance in a positive light.  A typical study or "white paper" takes a snapshot of hedge fund performance and either state or implies that the performance in that time period is indicative of hedge fund performance in general. At the same time as the industry piles on analyses, academics have been studying the issue with more rigor and over a longer time frame.  However, academics don't have the stage or the resources to counter the industry's voice. It is therefore a hugh service to investors to have the academic research of the past two decades synthesized in a recent paper by two recent papers: Vikas Agarwal, Kevin A. Mullally and Narayan Y. Naik in an August 2015 paper, Hedge Funds: A Survey of Academic Literature,” and Hedge Funds: A Dynamic Industry in Transition,” by Mila Getmansky, Peter Lee and Andrew Lo. The summaries cover the research of over 200 academic articles spanning "hedge fund era" of 1990 until today.  The findings are highly critical of the claims made by hedge funds for their own performance.  Below are representative findings of these research summaries:

1. Hedge fund return-generating processes
   1. Hedge fund performance is largely determined by exposure to systemic risk (emerging market currencies and equities determine global macro performance)
   2. Fixed income arbitrage strategies…are highly profitable but carry enormous downside risk when CDS spreads widen
      1. Carry trade explains 16% of hedge fund index and 33% of fixed income arbitrage fund returns
   3. Betas on default premium and inflation rate have significant power in explaining the variation of hedge fund returns
2. Manager skill in hedge funds
   1. “The performance of top hedge funds cannot be attributed to chance along” …However, there is a need “of conditioning on macroeconomic variables when identifying managerial skill.”
3. Performance Persistence
   1. “performance persistence is scarce and, if present, only lasts for very short horizons;” “one’s proprietary strategy is the prime determinant of persistence, not managerial skill.”

 

1. Relation between investor flows and fund performance
   1. All these studies can explain only a small fraction of the variation in flows
2. “alpha changes dramatically through time, across categories and is related to the level of competition among hedge funds.”
3. “Managerial alpha is, in fact, attributable to “exotic betas”, or hedge-fund managers generate alpha when macro conditions are conducive.”
4. “hedge fund managers are only marginally better than mutual-fund managers in stock picking…”
5. “The evidence regarding performance persistence is mixed.”

The findings are starkly at odds with the viewpoint presented by the industry. What comes across is widespread disagreement about methodology and findings; negative or ambiguous results; a paucity of studies and data; and little effort to implement any of the research in a market or trading setting.