Higher risk,lower returns: What hedge fund investors really earn

The returns of hedge fund investors depend not only on the returns of the funds they hold but also on the timing and magnitude of their capital flows in and out of these funds. We use dollar-weighted returns (a form of Internal Rate of Return (IRR)) to assess the properties of actual investor returns on hedge funds and compare them to buy-and-hold fund returns. Our main finding is that annualized dollar-weighted returns are on the magnitude of 3% to 7% lower than corresponding buy-and-hold fund returns. Using factor models of risk and the estimated dollar-weighted performance gap, we find that the real alpha of hedge fund investors is close to zero. In absolute terms, dollar-weighted returns are reliably lower than the return on the Standard & Poor's (S&P) 500 index, and are only marginally higher than the risk-free rate as of the end of 2008. The combined impression from these results is that the return experience of hedge fund investors is much worse than previously thought.     

The liquidity risk of liquid hedge funds

This paper evaluates hedge funds that grant favorable redemption terms to investors. Within this group of purportedly liquid funds, high net inflow funds subsequently outperform low net inflow funds by 4.79% per year after adjusting for risk. The return impact of fund flows is stronger when funds embrace liquidity risk, when market liquidity is low, and when funding liquidity, as measured by the Treasury-Eurodollar spread, aggregate hedge fund flows, and prime broker stock returns, is tight. In keeping with an agency explanation, funds with strong incentives to raise capital, low manager option deltas, and no manager capital co-invested are more likely to take on excessive liquidity risk. These results resonate with the theory of funding liquidity by Brunnermeier and Pedersen (2009).     

Should investors invest in hedge fund-like mutual funds? Evidence from the 2007 financial crisis

This study empirically examines the value added for investors during the 2007–2009 financial crisis from hedge fund-like equity mutual funds, including 130/30, market neutral, and long/short equity funds. We find that based on the information ratio, all market neutral funds, top 90% of long/short funds, and top 25% of 130/30 funds outperform a long-only passive index fund over the crisis period. However, we find little evidence of abnormal performance by the average and median funds in our sample, based on either unconditional or conditional four-factor alphas. The reason for the overall under-performance in the crisis period is that while short positions taken by these funds do generate alpha, the gain from their short positions is not sufficiently large to offset the loss from their long positions. Finally, the abnormal performance of short positions is found to be attributable to managers’ characteristic-adjusted and industry-adjusted stock selection skills. One implication of this study is that even though market neutral and long/short funds on average may not generate alpha, investors can benefit from holding these funds, especially the former, that can provide a hedge against down markets due to their low betas and that can be useful for asset allocation.     

Do hedge funds deliver alpha? A Bayesian and bootstrap analysis

Using a robust bootstrap procedure, we find that top hedge fund performance cannot be explained by luck, and hedge fund performance persists at annual horizons. Moreover, we show that Bayesian measures, which help overcome the short-sample problem inherent in hedge fund returns, lead to superior performance predictability. Sorting on Bayesian alphas, relative to OLS alphas, yields a 5.5% per year increase in the alpha of the spread between the top and bottom hedge fund deciles. Our results are robust and relevant to investors as they are neither confined to small funds, nor driven by incubation bias, backfill bias, or serial correlation.     

Systematic risk and the cross section of hedge fund returns

This paper investigates the extent to which market risk, residual risk, and tail risk explain the cross-sectional dispersion in hedge fund returns. The paper introduces a comprehensive measure of systematic risk (SR) for individual hedge funds by breaking up total risk into systematic and fund-specific or residual risk components. Contrary to the popular understanding that hedge funds are market neutral, we find that systematic risk is a highly significant factor explaining the dispersion of cross-sectional returns while at the same time measures of residual risk and tail risk seem to have little explanatory power. Funds in the highest SR quintile generate 6% more average annual returns compared with funds in the lowest SR quintile. After controlling for a large set of fund characteristics and risk factors, systematic risk remains positive and highly significant, whereas the relation between residual risk and future fund returns continues to be insignificant. Hence, systematic risk is a powerful determinant of the cross-sectional differences in hedge fund returns.     

The performance and diversification benefits of funds of hedge funds

We examine the performance and diversification potential of 332 funds of hedge funds (FOHFs) for the period from January 1990 to May 2003. Consistent with prior studies, we find that FOHFs appear to underperform the hedge fund index on a risk-adjusted basis. However, FOHFs have characteristics that offset their apparent underperformance. Their returns do not suffer from negative skewness that is a feature of many hedge fund strategies. Relative to the hedge fund index, we find that FOHFs have lower correlations with stock indices in both bull and bear markets, making them a better diversification tool in equity portfolios. For bond portfolios, however, FOHFs have no diversification advantage over hedge fund indexing.     

Does the choice of performance measure influence the evaluation of hedge funds?

The Sharpe ratio is adequate for evaluating investment funds when the returns of those funds are normally distributed and the investor intends to place all his risky assets into just one investment fund. Hedge fund returns differ significantly from a normal distribution. For this reason, other performance measures for hedge fund returns have been proposed in both the academic and practice-oriented literature. In conducting an empirical study based on return data of 2763 hedge funds, we compare the Sharpe ratio with 12 other performance measures. Despite significant deviations of hedge fund returns from a normal distribution, our comparison of the Sharpe ratio to the other performance measures results in virtually identical rank ordering across hedge funds.     

Synthetic hedge funds

We provide evidence on the performance and the replication success of a broad sample of 72 synthetic hedge funds from January 2009 to December 2013. Thereby, we assign the term “synthetic hedge fund” to mutual funds and exchange-traded funds with hedge fund indices as their benchmarks. Replication success is measured through different perspectives from distributional characteristics to risk-adjusted performance. We find an overall significant underperformance of synthetic hedge funds compared to an appropriate benchmark index. Furthermore, mutual funds (associated with active portfolio management) can produce return characteristics closer to hedge fund benchmarks than exchange-traded funds (associated with passive management) can. From a single strategy perspective, we find a picture of heterogeneity. Regarding the market environment, we show larger return differences for unusual market conditions than for regular ones.     

Style analysis and Value-at-Risk of Asia-focused hedge funds

In this paper we identify risk factors for Asia-focused hedge funds through a modified style analysis technique. Using an Asian hedge fund index, we find that Asian hedge funds show significant positive exposures to emerging equity markets. For both a static and rolling period style analysis, our model provides a high explanatory power for returns of the considered hedge fund index. We further conduct a Value-at-Risk analysis using the results of a rolling window style analysis as inputs. Our findings suggest that the considered parametric models outperform a simple historical simulation that is purely based on past return observations.     

Capturing hedge fund risk factor exposures: Hedge fund return replication with ETFs

We develop a new factor selection methodology of spanning the space of hedge fund risk factors with all available exchange traded funds (ETFs). We demonstrate the efficacy of the methodology with out-of-sample individual hedge fund return replication by ETF clone portfolios. This is consistent with our interpretation of ETF returns as proxies to risk factors driving hedge fund returns. We further consider portfolios of “cloneable” and “noncloneable” hedge funds, defined as top and bottom in-sample R² matches, and demonstrate that our ETF clone portfolios slightly outperform cloneable hedge funds out of sample.     

Alpha or beta in the eye of the beholder: What drives hedge fund flows?

Capital Asset Pricing Model (CAPM) alpha explains hedge fund flows better than alphas from more sophisticated models. This suggests that investors pool together sophisticated model alpha with returns from exposures to traditional (except for the market) and exotic risks. We decompose performance into traditional and exotic risk components and find that while investors chase both components, they place greater relative emphasis on returns associated with exotic risk exposures that can only be obtained through hedge funds. However, we find little evidence of persistence in performance from traditional or exotic risks, which cautions against investors’ practice of seeking out risk exposures following periods of recent success.     

Speculators,commodities and cross-market linkages

We use a unique, non-public dataset of trader positions in 17 U.S. commodity futures markets to provide novel evidence on those markets' financialization in the past decade. We then show that the correlation between the rates of return on investible commodity and equity indices rises amid greater participation by speculators generally, hedge funds especially, and hedge funds that hold positions in both equity and commodity futures markets in particular. We find no such relationship for commodity swap dealers, including index traders (CITs). The predictive power of hedge fund positions is weaker in periods of generalized financial market stress. Our results support the notion that who trades helps predict the joint distribution of commodity and equity returns. We find qualitatively similar but statistically weaker results using a proxy for hedge fund activity based on publicly available data.     

Incentives and risk taking in hedge funds

We study how incentive fees and manager’s own investment in the fund affect the investment strategy of hedge fund managers. We find that loss averse managers increase the risk of the fund’s investment strategy with higher incentive fees. However, risk taking is greatly reduced if a substantial amount of the manager’s own money (at least 30%) is in the fund. Using the Zurich hedge fund universe, we test the relation between risk taking and incentive fees empirically. Hedge funds with incentive fees have significantly lower mean returns (net of fees), while downside risk is positively related to the incentive fee level. Fund of funds charging large incentive fees achieve relatively high mean returns, but with significantly higher risk as well.     

Structural holes and hedge fund return comovement: evidence from network-connected stock hedge funds in China

Using data from a new hedge fund database, we examine the impact of social networks on the return comovement of stock hedge funds in China. We use structural holes in the college alumni networks of managers to measure the managers’ social network positions. We perform an empirical analysis on a sample of 3,012 hedge fund products in China from 2010 to 2017. We find that greater structural holes are associated with higher return comovement. The positive impact of the structural holes on return comovement is not affected by market cycles, a manager's major in college, or his or her abilities.     

Macroeconomic risk and hedge fund returns

This paper estimates hedge fund and mutual fund exposure to newly proposed measures of macroeconomic risk that are interpreted as measures of economic uncertainty. We find that the resulting uncertainty betas explain a significant proportion of the cross-sectional dispersion in hedge fund returns. However, the same is not true for mutual funds, for which there is no significant relationship. After controlling for a large set of fund characteristics and risk factors, the positive relation between uncertainty betas and future hedge fund returns remains economically and statistically significant. Hence, we argue that macroeconomic risk is a powerful determinant of cross-sectional differences in hedge fund returns.     

Risk and return in convertible arbitrage: Evidence from the convertible bond market

In this paper, we identify and document the empirical characteristics of the key drivers of convertible arbitrage as a strategy and how they impact the performance of convertible arbitrage hedge funds. We show that the returns of a buy-and-hedge strategy involving taking a long position in convertible bonds (“CBs”) while hedging the equity risk alone explains a substantial amount of these funds' return dynamics. In addition, we highlight the importance of non-price variables such as extreme market-wide events and the supply of CBs on performance. Out-of-sample tests provide corroborative evidence on our model's predictions. At a more micro level, larger funds appear to be less dependent on directional exposure to CBs and more active in shorting stocks to hedge their exposure than smaller funds. They are also more vulnerable to supply shocks in the CB market. These findings are consistent with economies of scale that large funds enjoy in accessing the stock loan market. However, the friction involved in adjusting the stock of risk capital managed by a large fund can negatively impact performance when the supply of CBs declines. Taken together, our findings are consistent with convertible arbitrageurs collectively being rewarded for playing an intermediation role of funding CB issuers whilst distributing part of the equity risk of CBs to the equity market.     

Liquidity shocks,size and the relative performance of hedge fund strategies

We examine whether the increase in the flow of capital to hedge funds over the period 1994–2005 had a negative impact on performance. More specifically, we study the relative performance of small versus large funds for each of the hedge fund strategies. Our results indicate that on an absolute return basis, small funds outperform large funds. On a risk-adjusted return basis, however, we find that large funds outperform small funds, and that large funds are also shown to hold less liquid assets and take on less systematic and idiosyncratic risk than small funds. Further, funds that experience positive liquidity shocks generally outperform those that experience negative liquidity shocks. We also find evidence that hedge fund managers that are aggressive in dealing with liquidity shocks perform better than hedge fund managers that are conservative in dealing with liquidity shocks.     

Emerging Market Exposures and the Predictability of Hedge Fund Returns

We examine emerging market and global macro hedge funds and find a significant positive relation between hedge funds’ future returns and their exposure to both emerging market equities and emerging market currencies. We present evidence that the strong predictive power of emerging market betas is related to the superior market‐timing ability of these fund managers. Results are robust after controlling for commonly used hedge fund factors, the emerging market equity index, lagged fund returns, liquidity risk, and fund characteristics. Our results suggest that hedge funds can earn positive excess returns by timing their exposure to emerging market securities.     

Changing investment styles: style creep and style gaming in the hedge fund industry

Notwithstanding their common features, hedge funds remain an extremely diverse asset class. Information on fund styles is important for numerous purposes, such as portfolio construction, performance attribution and risk management. With fund self‐declaration being prone to (strategic) misclassification, return‐based taxonomies grouping funds along similarities in realized returns provide a useful alternative. We provide a consistent classification system of homogeneous groups of hedge funds based on self‐organizing maps. Whereas some fund categories such as managed futures are largely consistent in their self‐declared strategies, others, especially so‐called ‘equity hedge’ funds, display no or very limited return similarities. Furthermore, we also find evidence of fund managers performing undisclosed changes of their trading style over time. Those funds that misclassified themselves once are particularly likely to change their trading style again. Although style self‐declaration can, therefore, be quite misleading, our results indicate that hedge funds do not misdeclare their style strategically to improve their relative performance. Copyright © 2006 John Wiley & Sons, Ltd.