According to a recent academic report by Ron Bird, Harry Liem and Susan Thorp of University of Technology, Sydney (click here to download) hedge fund managers, like many of their mutual fund cousins display zero market timing ability and zero alpha-producing ability.
To get to their conclusion, the report’s authors constructed a time-varying factor model of hedge fund returns that accounted for market risk, leverage, illiquidity and tail events. They also adjusted for database biases arising from voluntary self-reporting.
Using a constant beta model, not only did they not find evidence of excess returns for the average hedge fund manager between 1994 and 2009, they found no evidence of alpha skill when allowing for time-varying beta, volatility clustering and leverage effects.
“In fact, allowing for dynamics in conditional mean and variance equations further erodes evidence of excess returns,” the authors note, without mincing words.
Pretty harsh stuff.
The group takes pains to measure various biases inherent in their methodology, including backfill and survivorship bias related to funds listed on the HFR database, which they used for their findings. For that they threw an average 2.8-3.8% overestimation of returns into their equations.
But they throw a couple of bones, too. “For the aggregate industry, the negative market timing ability is somewhat offset by the increased alpha from security selection,” the authors note.
Even so, the report makes plain that after all is said and done hedge funds provide no alpha to their investors and capture rents commensurate with their abilities. In fact, to the contrary, the report concludes that hedge fund managers are (wait for it) poor market timers.
And, to put a cherry on the cake, the report’s authors conclude that the only corollary is that hedge fund managers are producing excess returns, but that they are retaining them via fees. (Ed: Silver lining: so HF managers do have skill, they just keep the benefits of that skill for themselves?) The chart below illustrates the general lack of excess returns among hedge fund managers between 2004 and 2009.
So what’s a hedge fund manager to do? According to the report, “focus his (sic) research efforts on security selection,” as most mutual fund managers do, or switch horses and run a global macro or managed futures fund, “which seem to offer the ability to hedge against tail events or stress periods and thus could be studied from an overall portfolio diversification context for institutional investors,” the report says.
As regular readers are aware, many studies have also found positive alpha among hedge funds. (click here for our prior coverage of whether alpha exists).
But it’s hard to argue with hard numbers and facts. As the chart above (and about a dozen charts on almost every hedge fund strategy published in the authors’ paper – see Fig. 2 page 27) demonstrates, the vast majority of hedge fund managers tend to jump into the same boat when the going gets tough, making it difficult to determine if they collectively produce alpha when the rest of the market is facing a maelstrom.
But wait! For every academic study that finds hedge funds produce no value, there seems to be another academic study that shows the opposite. Perhaps academia is learning one important lesson from the alternative investment industry: it’s good to be hedged.