Research shows hedge fund managers not just overpaid, blindfolded dart-throwers

Questioning whether a hedge fund manager is any good at picking stocks is a bit like questioning whether Wayne Gretzky knows how to skate or Lance Armstrong knows how to ride a bike. By and large, Wayne, Lance and most alternative investment managers would find the question just a bit insulting.

Lucky for them, research by Wesley Gray of the University of Chicago and Andrew Kern of the University of Missouri affirms that they certainly are good at picking stocks and not just absurdly lucky.

Indeed, the paper entitled Do Hedge Fund Managers Have Stock-Picking Skills summarizes the authors’ clinical study of investment recommendations submitted to (VIC), a private-access club with a membership base consisting primarily of smaller fundamentals-based hedge fund managers and their associates.

Their conclusion: An overwhelming amount of evidence shows that the hedge fund managers do exhibit skill when it comes to selecting stocks and earning a return for their investors.

And then some, according to the raw returns compiled. The average one-, two-, and three-year raw returns of long recommendations submitted to the site between January 1, 2000 and December 31, 2008 were 17.11%, 45.02%, and 74.39%, respectively. After controlling for market risk, size risk, book-to-market exposure, and momentum risk via a control portfolio, the authors found excess one-, two-, and three-year returns of 9.52%, 19.03%, and 23.60%, respectively  (the chart below illustrates buy and hold abnormal return, or BHAR, from 1 month to 3 years).

“These results are all highly statistically significant and are well in excess of any management and performance fees these managers charge their investors,” the authors note.

But to truly convince those who think hedge fund managers are really just overpaid dart-throwers, the authors analyzed various VIC recommendations using a rating system as a proxy for an idea’s future outperformance. For example, an idea with a rating of “2” from the VIC community should produce less outperformance than an idea with a rating of “8.”

What they found was that the average raw return to ideas rated in the top 20% of all ideas submitted had one-, two-, and three-year raw returns of 27.76%, 46.59%, and 86.86%, respectively. Meanwhile, ideas rated in the bottom 20% of all ideas submitted have one-, two-, and three-year raw returns of 8.56%, 32.62%, and 46.25%, respectively.

After controlling for risk, the highest rated ideas provide alpha of 21.69%, 26.15%, and 42.58% on a one-, two-, and three-year horizon, whereas, the lowest rated ideas provide alpha of -.16%, 4.21%, and -9.02%, over the same time periods (see chart below).

Translation: hedge fund managers sure can pick ‘em, and the rewards of finding “good” managers, like those involved with VIC, are certainly high enough to justify the increased fees they likely charge. “This provides preliminary evidence that the active money management industry’s primary product isn’t snake oil,” say the authors.

Of course, one could easily argue that one small segment of the stock-picking market does not a widespread trend make. After all, gauging an entire industry’s collective abilities on is a bit like evaluating the entire medical profession’s skill set based on experiences at a strip mall walk-in clinic in des Moines.

Still, hedge fund managers and highly active long-only managers are likely more than happy to take Gray and Kern’s research and analysis as a feather in their cap.

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