What Explains Hedge Fund Returns?

Hint: it's not just luck (or factor analysis...or risk premia...)

February 7, 2011

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1068361_good_luck“But being as this is a 4.4 Sharpe ratio, the most skilled performance in the world, and would blow your beta clean off, you’ve got to ask yourself one question: Do I feel lucky? Well, do ya punk?”

Are hedge funds for real? Some have suggested that they may be leveraged beta plays – with stale data obscuring the market correlation. Others have pointed to exotic beta – the returns that come from buying illiquidity risk, or credit risk or small-cap risk, among other things. Still others suggest it’s the luck of the market cycle – at least if you happen to be in a rising one.

In the end, then, one could replicate hedge fund returns by tapping the right premia, being prescient about the market cycle, and then leveraging up, suggests some of the academic literature.

But, according to Hyuna Park, assistant professor in the College of Business at Minnesota State University, Mankato, factor analysis and risk premia do not really explain hedge fund returns. Nor does luck.

Park uses a framework developed by Harris and Harris Professor Andrew Lo at MIT’s Sloan School of Management that decomposes hedge fund returns into factor timing, risk premia and security selection, as well as the seven-factor model initiated by William Fung and David Hsieh, respectively Visiting Research Professor of Finance at the London Business School and Bank of America Professor of Finance at Duke University’s Fuqua School of Business.

For her paper, “Can Factor Timing Explain Hedge Fund Alpha?, Park uses the Tremont Advisory Shareholders Services database of 6114 hedge funds over the period 1994-2008.

She finds “that hedge funds on average do not show timing ability in the US equity market despite their advantage over registered investment companies such as mutual funds in terms of using leverage and short sales.”

For example, as the financial crisis seized hold of equity markets, and the S&P 500 turned sharply negative on a monthly basis, hedge funds were increasing their exposure. “In fact, security selection explains more than 100% of the excess return, and the proportion explained by factor timing is negative.” But that’s for illiquid hedge funds – ones that do not report returns daily. As a cross-check, Park also uses the HFRX indices, which do report daily prices. As a result:

“In liquid-style hedge funds, factor timing contributes to generating excess return but its contribution is much smaller than that of security selection. For example, among the excess return of 0.64% per month delivered by the equally weighted portfolio of 2924 liquid-style hedge funds during 1994-2008, security selection generated 0.50%, factor timing generated 0.11%, and the remaining 0.03% is the risk premium.”

But skill exacts its toll. She concludes: “The existence of ‘hot hands’ in hedge funds is not because of loose regulation that enhances factor timing potential. The main reason is managers with security selection skills attracted to the hedge fund industry that has incentive fees.”

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