Hedge funds promise sophisticated strategies and the potential for market-beating returns, but do they deliver enough value to justify their high fees? Research reveals a mixed picture. While some hedge fund managers demonstrate impressive skills in stock-picking or market timing, their overall performance often falls short of standard indices.
For investment professionals, the challenge lies in identifying the few managers who combine skill, performance, and persistence. This is the first in a series of three blog posts that explore the hedge fund literature.
Skill
I found mixed evidence that hedge fund managers have investment skills. In fact, their investment outcomes are not much better than what you could expect from mere luck. However, several papers indicate that the best managers stand out.
Kosowski et al. (2007) found that top hedge fund performance cannot be explained by luck. Chen and Liang (2009), looking at a sample of 227 market-timing hedge funds from 1994 to 2005, found evidence of market timing skill, especially during bear markets and volatile market conditions. Nohel et al. (2010) compared the returns of mutual funds run by managers who also manage hedge funds with the returns of other mutual fund managers, finding the former significantly outperforming the latter.
More recently, Aiken and Kang (2023) found that hedge fund managers have stock-picking skills that diminish over time but do not find evidence of market timing skills. Barth et al. (2023) found that hedge funds not listed in commercial databases generated up to $600 billion in value-added (before fees) returns from 2013 to 2019.
Other studies identify characteristics that may help pick out skilled hedge fund managers. Agarwal et al. (2009) found that hedge funds with greater managerial incentives, higher levels of managerial ownership, and the inclusion of high-water-mark provisions are associated with superior performance. They also found that funds with a higher degree of managerial discretion, proxied by more extended lockup notice and redemption periods, deliver superior performance. Sun et al. (2012) devised a “Strategy Distinctiveness Index.”
Funds with a higher index were associated with better subsequent performance. After adjusting for risk, funds in the highest SDI quintile outperformed funds in the lowest quintile by 3.5% in the following year. Cao et Al. (2021) found that start-up hedge funds launched during periods of low demand for this type of fund outperformed those launched in high-demand periods.
Performance
On balance, research does not suggest impressive performance from hedge funds.
Ackermann et al. (2002) found that hedge funds consistently outperform mutual funds but not standard market indices. They also found hedge funds to be more volatile than mutual funds. Kosowski et al. (2007) reported that hedge funds generate statistically insignificant alphas in five of the six categories reviewed: long/short, directional, multi-process, security selection, and funds-of-funds. The authors also mentioned that long/short equity funds’ residuals are negatively skewed, and relative value funds exhibit high kurtosis, or higher than normal frequency of extreme outcomes.
By contrast, Newton et al. (2019), studying 5,500 North American hedge funds that followed 11 different strategies from 1995 to 2014, found that all but two hedge fund strategies outperformed the market as stand-alone investments, although their manager skill level was low.
Sullivan (2021) analyzed the performance of hedge funds during the 1994–2019 period, dividing his data into two subsamples. From 1994 to 2008, he found an alpha of 3.4% annually. However, for the more recent 2009 to 2019 period, he found a ‑1.0% alpha. The author concludes that hedge fund performance may have declined over time due to reduced exposure to active management risk. Two other studies, Eksi and Kazemi (2022) and Amir-Ghassemi et al. (2022), confirmed the fading of hedge fund performance since 2009. By contrast, Barth et al. (2023) claimed that from 2013 to 2019, non-listed hedge funds produced, on average, positive alphas. However, Swedroe (2024) has challenged this claim, arguing that while the average non-listed fund may have added value, the median fund (a more representative statistical figure) does not.
Persistence
A key measure of whether the best hedge fund managers outperform by luck or by skill is persistence. Do the best-performing hedge funds tend to repeat their outperformance in subsequent periods? Unfortunately, with one notable exception, most studies find significant hedge fund persistence over short periods that vanishes at longer horizons.
Baquero et al. (2005) reported positive persistence in hedge fund quarterly returns after correcting for investment style, with weakly significant annual persistence. Kosowski et al. (2007) also found that the best hedge funds persisted at annual horizons. Agarwal et al. (2009) found maximum persistence at the quarterly horizon, indicating that persistence among hedge fund managers is short-lived. Sun et al. (2018) reported evidence that hedge fund performance is persistent following weak hedge fund markets but is not persistent following strong markets. Aiken and Kang (2023) found weak evidence that managers exhibit persistence in selectivity skills.
In a noteworthy study, Barth et al. (2023) found that, in contrast to vendor-listed funds, significant persistence existed over all horizons among non-listed hedge funds in 2013–2019, providing hope that outperforming hedge funds can be identified in advance.
Key Takeaway
Overall, research suggests skill and alpha are scarce and difficult to obtain in the hedge fund market, especially among those listed in commercial databases. Furthermore, most studies report that outperformers fail to repeat their feats over long periods. Investors considering hedge funds should not overlook unlisted funds.
In my next post, I will discuss hedge fund risk and diversification properties.
