Study examines “mulligans” in hedge fund performance data

Golfers are familiar with the term “mulligan” – the practice of re-doing a tee shot if the golfer duffs the ball into the woods, onto the next fairway or over the fence into someone’s backyard.  God knows, we are quite familiar with mulligans at

According to the US Golf Association:

“Mr. Mulligan was a hotelier in the first half of the [20th] century, a part-owner and manager of the Biltmore Hotel in New York City, as well as several large Canadian hotels. One story says that the first mulligan was an impulsive sort of event – that one day Mulligan hit a very long drive off the first tee, just not straight, and acting on impulse re-teed and hit again. His partners found it all amusing, and decided that the shot that Mulligan himself called a ‘correction shot’ deserved a better named, so they called it a ‘mulligan.'”

There has been considerable debate over the years about whether hedge fund managers have been giving themselves mulligans when they occasionally shank their new funds into the drink.  Since hedge fund managers voluntarily report their performance to the major databases (which form the foundation for most academic studies), it is felt that only their best funds eventually make it on the list – and when they do, the performance since inception is “back-filled” into the database to create what is often referred to as an “instant track record”.  The result is that the returns reported by so-called “emerging managers” are not really a true representation of all attempts to launch new funds.

But what can be done to get a truer picture of all hedge fund launches?  If you were analyzing golf shots, for example, you might walk through the adjacent woods and backyards to count the number of failed tee-shots.  But that’s not possible in the hedge fund industry where managers are more likely to close a poorly performing fund and pretend it never existed.

However, a recently updated paper by Rajesh Aggarwal of the University of Minnesota (not to be confused with Vikas Agarwal, a leading hedge fund researcher at Georgia State University) and Philippe Jorion of the University of California accounts for these hedge fund mulligans by, essentially, counting every shot.  The pair describes their paper as “the first systematic analysis of performance patterns for emerging hedge fund managers.”

Aggarwal and Jorion analyze funds that were entered into databases almost contemporaneously with their actual launch (median time between launch date and initial reporting date: 82 days, vs. 480 days for all funds).  This is analogous to a golfer promising his shot will count before he takes it (or at least as he’s swinging the club).  In other words, they ignore managers who waited to confirm they had a winning fund before they went public with it.

Those who invest in emerging managers will be pleased to learn that even after this correction, emerging managers still apparently bring their “A-game” to the course.

The gray line in the chart above (taken from the paper) shows the cumulative alpha of funds that “back-filled” when they first reported to the database.  The blue line shows the cumulative alpha of only those new funds that started to report very soon after their launch.  But what is really striking is the red line – which shows the performance of the “back-filled” funds without the benefit of their “back-filled” data.  In this case, the horizontal axis represents the months since the fund began reporting, not months since fund inception as in the other two cases.

This suggests that managers who back-fill with (usually positive) data when they enter databases are actually more likely to underperform than those managers who do not back-fill.  In other words, it seems that managers who essentially renounce mulligans are more likely to do better in the long run.

In any case, as the authors point out,

“…a portfolio of backfilled funds that includes the backfilled period gives a totally unrealistic view of the performance of emerging managers.”

And so it seems that emerging managers may actually be a great place to invest after all.  In fact, the authors say that emerging managers also display another magical, alpha-generating property: “return persistence”.

“…when we form portfolios of emerging funds, we find that early performance (up to five years) is persistent. Importantly, the persistence we find is present both for the best performing quintile and the worst performing quintile of hedge funds. This result is important because earlier studies of performance persistence tend to find performance persistence amongst only the worst performing funds.”

Still, one would be excused for wondering if the smaller size of new funds, not their young age, was the secret to their success.  But Aggarwal and Jorion control for size and find that age is still a key determinant of success.

The authors conclude:

“…we find strong evidence that, for individual managers, early performance is quite persistent.  We find performance is persistent for up to five years for emerging managers.  Thereafter, performance persistence fades away, along with the outperformance we also document.  Thus, as predicted by theory, emerging managers tend to add value relative to their more established peers.”

In other words, golfers fresh out of the clubhouse tend to perform well on the front nine, even when you count the mulligans.

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