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A handful of very active hedge fund managers can outperform the rest, says a new discussion paper that should give much-maligned hedge fund managers a lift.
In a study published Monday by the Board of Governors of the U.S. Federal Reserve, Vassar University economist Ergys Islamaj and Fed research assistant Maziar Kazemi find that more active hedgies' performance compares favourably to their less active peers. The results could dampen some of the enthusiastic hedge fund bashing that has emerged recently, though the authors caution that the broad variations in the performance of very active managers puts a lot of emphasis on the importance of picking the right one.
The study surveyed monthly performance data of 2,687 equity long-short funds from 1994-2013, looking both for risk-adjusted and unadjusted returns. On a non-risk-adjusted basis, the top 25 per cent of more active managers produced broadly higher returns than less active ones, though as one might expect, they also produced significantly higher volatility.
When the returns are adjusted for risk, however, using Sharpe ratios and Jensen's alpha – two standard measures of risk-weighted performance – the authors find that the returns of the more active managers aren't high enough to compensate for the bets they make. Given that the study includes both live and dead funds, it seems safe to assume that some of the ones taking outsized risks may have blown up. "We can conclude that most active fund managers do not have the skills to manage the risks generated by their trading strategies," the authors write.
Arguably the most interesting finding is that the highly active funds show better risk-weighted returns than the moderately-active ones. "We may conclude that the highly active managers tend to be more skilled in managing the risk of their portfolios," the authors say, adding that "only a small group of the most active managers posses the skills to overcome the higher transaction cost [of trading often] and provide positive risk-adjusted alphas."
The paper concludes with the assertion that investors "need to spend more resources on due diligence and manager selection when considering active equity long-short managers," though it doesn't specify how. This in itself is a problem, given the well-documented difficulty of selecting a fund manager – those who've outperformed in recent years tend to be regarded as darlings and attract huge inflows from clients, only to see their returns revert to the mean for what can be painfully long periods.
Still, although hedge funds as a group have famously underperformed the S&P 500 for the past five years, Mr. Islamaj and Mr. Kazemi's paper suggests that not all hedge funds are created equal, and that there may yet be a way to figure out which of those funds are more equal than the others.