Study finds that factor timing isn’t actually a huge source of hedge fund alpha

CAPM / Alpha Theory 16 Mar 2011

When it comes to investing, the best insight is inevitably hindsight – knowing the exact times and places of when to get in, when to get out and when to stand by and watch the train wreck.

At no time is that more the case than when markets are churning and gyrating thanks to events that few (if any) saw coming. The 2008 financial market collapse being the most obvious economic example, but other less market-oriented events that have the potential to cause systemic risk: Middle East turmoil and an earthquake in Japan being recent not-thought-possible tragedies.

A recent paper by Hyuna Park of Minnesota State University entitled Can Factor Timing Explain Hedge Fund Alpha? (click here to download from SSRN) takes a closer look at factor timing and systemic risk, and how hedge funds fare during times of uncertain capital preservation and broader returns, particularly in terms of their ability to generate alpha.

What the researchers concluded is that, thanks to less regulation and more access to leverage and short sales, hedge funds are in a better position than mutual funds to anticipate systematic risk factors.

To get to whether factor timing is indeed a source of hedge fund alpha, the paper decomposed excess return generated by hedge funds during 1994 – 2008 into security selection, factor timing and risk premium. While security selection explains most of the excess returns generated by hedge funds (go active management!), the contributions of factor timing and risk premium are deemed trivial.

The implicit question addressed is one that has long been debated within and without hedge funds circles: Are hedge funds worth the price?  Any ETF or index-focused manager will flat out tell you that the hedge funds that truly generate alpha are few and far between; a traditional portfolio manager will most likely agree.

Yet, the paper’s author noted how his sampling indicates positive alpha appears more often in hedge funds than in mutual funds – this is even after adjusting for the high fees hedge fund managers typically charge. The chart below illustrates time-varying market risk premium (i.e. how market participants respond to risk) and daily index beta. The former clearly outshines the latter, though with what would appear to be slightly more volatility.

“Is it because the incentive fee of hedge funds can attract managers with security selection skills, or because hedge funds are better positioned than mutual funds for timing systematic risk factors due to looser regulation?,” as asked in the paper.

Apparently, at least to a degree, it is a matter of skill. But it’s also the ability to be more nimble and utilize a lot more resources so that hedge funds get the better seat on the alpha generation train. They can change their loadings on systematic risk factors more freely because they are less regulated, and in turn are in a better position to generate alpha using factor timing.

Which leads to the next question: Can factor timing explain hedge fund alpha?

In short, the answer is no. While hedge fund managers are able to produce alpha based on their own skill set and with some extra tools at their disposal – based on empirical study of returns over a 14-year period leading up to the 2008 financial crisis – factor timing was not at all a part of what allowed hedge fund managers to one-up their mutual fund compatriots.

“I find that hedge funds on average do not show timing ability in the U.S. equity market despite their advantage over registered investment companies such as mutual funds in terms of using leverage and short sales,” the report’s author noted. “Especially, the individual fund level test using illiquid-style hedge funds in TASS shows that the covariance between the U.S. equity market beta and risk premium is negative and significant at the 1% level.”

In other words, not only do hedge funds not show much prowess in the timing ability department, they actually take a hit themselves when they try to utilize it.

The moral of the paper: Hedge funds are certainly capable of producing alpha and generally are better at it than other kinds of money managers. This is thanks to the certain tools they have that others don’t and, more importantly, to their skill set of being able to time security selection and other investing elements in ways that, despite 2008’s massive hedge fund losses, still allows them to outperform.

So 2 and 20 is A-O-K, especially when it comes to generating alpha and simultaneously circumventing broader risk. We know quite a few non-hedge fund types who would strongly disagree.

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