Is previous research on hedge fund performance persistence “biased”?

By now, most hedge fund investors are aware that absolute, raw returns may not be the best way to judge a hedge fund manager.  Many believe that removing betas (whether they be “traditional” or “alternative”) from the equation can provide a more useful indication of manager ability.  For them, the question then becomes: did the manager beat their beta benchmark?

That much is generally agreed.  But for any given period, a large portion of managers beat their benchmarks and a large portion lag their benchmark.  In fact, if the benchmark is the average performance of all managers pursuing the same strategy then approximately half of all managers would beat the benchmark and half would lag it simply due to luck – not ability.

However, if the manager persistently finds herself on the winning side of the average, then one can likely conclude she has true ability.  Being on the winning side twice in a row may not say much.  But some managers appear to deliver returns that are as persistent as the sun rising every morning.  Thus was born the study of manager “persistence”.

Evidence of persistence in the mutual fund industry is inconclusive.  But some studies of hedge funds have suggested that those at the top of the league tables are slightly more likely to be there again than those further down the list (or those whose results are below average).  According to the authors, these studies conducted in 1999 and 2003 found little evidence of hedge fund persistence, while these ones conducted in 2000, 2004 and 2005 found that the best performing managers do show some statistically significant persistence.

But this 2007 study by Matteo Belleri of fund-of-funds manager Schroders and Marco Navone of business school SDA Bocconi takes issue with those studies.  Say the authors:

“…the vast majority of the relevant contributions is focused on the persistence of funds total return. Only a small number of articles try to analyze the persistence of fund managers ability measured as the difference between fund return and the performance of an index of hedge funds with the same strategy.”

So instead of just looking at absolute performance, the duo looked at “manager ability” – an ability to beat similar funds (grouped according to a three-year regression, not the managers’ stated strategies), across over 3,000 hedge funds from 1994 to 2005.

Consistent with the findings of previous studies, Matteo and Navone found that there was, in fact, top decile persistence in absolute fund returns and also in fund returns in excess of stated strategy.

But when they applied a new measure of “manager ability” (outperformance above the strategy divined from a regression of three year returns), they found that only the worst (bottom decile) managers showed persistence.  In other words, bad funds persistently stank.  And contrary to previous studies, they found that the best managers were actually unable to remain top decile for very long.

So how do they explain this apparent inconsistency?  In their words:

“Reconciling these two evidences we can conclude that the top performers ability evidence found in literature is mainly due to a distortion in the definition of ability: if the fund manager consistently follows a strategy that is different from the stated one (what we call a style bias), persistence in the strategy itself will be wrongly attributed to manager ability.”

“The clearest interpretation of the evidence of top performer persistence in total returns and bottom performers persistence in managers ability is that there may be a persistence of top performing strategies with a spillover on raw returns.”

So it appears that, like in traditional long-only investing, most returns may come from asset allocation, not manager selection.  The authors even suggest that a “two-step” fund of funds process involving strategy allocation and manager selection may be fruitless due to what is effectively a lack of manager persistence within each strategy group.

This finding is important for funds of funds, say the authors, because funds of funds that pick managers solely based on performance may unwittingly be delegating strategy allocation decisions to their stable of sub-managers – most of whom dynamically pursue strategies that are actually different from their stated ones.  Warns the report:

“If we measure the ability performance using the active return…we basically fail to differentiate between strategy and ability return. So the evidence that many authors have found in literature about the persistence of the ability of the best hedge fund manager is biased by the fact that many funds follow a strategy that is intrinsically different from the stated one or that can be better represented by a different mix of strategies.”

While it may be true that even the best managers eventually fall on hard times, the presence of at least some non-normal return persistence leads to alpha.  Beating the benchmark in one year may be luck – same in a second year – even in the third.  But bucking the (Gaussian) odds for several years in a row suggests something more than chance.  The big question, according to this paper, is apparently the definition of “benchmark”.

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