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BAM Intelligence

Hedge Funds Don’t Hedge

Mikhail Tupitsyn and Paul Lajbcygier, authors of the August 2015 paper “Passive Hedge Funds,” sought to answer the question: Do most hedge fund managers generate returns through managerial skill?

Their hypothesis was: “In order to demonstrate skill, a hedge fund manager must generate enhanced performance through active management. Such skill should be manifest through nonlinear exposure to the systematic risk factors that drive hedge fund returns and as a consequence of active management outperformance should ensue.” Note that nonlinear models have payoff structures such as those often found in options.

To explore this issue, the authors used a Credit Suisse/TASS database covering the period January 1994 to September 2010. The data included TASS hedge fund indexes for convertible arbitrage, dedicated short bias, emerging markets, equity market neutral, event-driven, fixed-income arbitrage, global macro, long/short equity, managed futures, multistrategy and fund-of-funds styles, in addition to a composite hedge fund index.

To mitigate the well-known survivorship and backfill biases in hedge fund data, the authors included funds from the TASS “graveyard” database, which stores historical data on defunct funds.

The final sample consisted of 5,580 hedge funds, of which 2,670 were active and 2,910 were defunct. The high percentage of defunct funds is itself an indicator of just how large a problem survivorship bias can be. The following is a summary of Tupitsyn and Lajbcygier’s key findings:

  • A large majority of hedge fund managers rely on “passive” linear risk exposures to generate their returns. In other words, many behave like alternative beta portfolios.
  • Only about 20 percent of hedge funds exhibit nonlinear exposure to systematic risk factors.
  • Funds with “passive” linear exposures outperform most “active” managers that try to deploy skill. On average, active (nonlinear) funds are inferior to linear (passive) funds in terms of both raw and risk-adjusted returns (they have lower Sharpe ratios). They also have greater negative tail risk (meaning they exhibit negative skewness and excess kurtosis).
  • Since most hedge fund strategies are significantly correlated with well-known risk factors, the results confirm that hedge fund strategies are not market neutral (they aren’t really hedging).
  • Each of the hedge fund styles analyzed, with the exception of the managed futures category, showed a statistically significant correlation with equity market returns. Said another way, they aren’t good hedges for equity exposures.

Passive Funds Don’t Stay Passive
Another finding of interest—at least as it relates to investors having the ability to identify the future outperformers based on prior performance—was that the majority of nonlinear funds that survive over the long term tend to alter their risk exposures and eventually become linear funds.

For example, the authors found that only 15 to 25 percent of funds with nonlinear exposures in one five-year period remain in the nonlinear class during the next five-year period. Even worse, they found that about 40 percent of nonlinear funds fail in the next period—and roughly the same proportion move to the linear class.

In reviewing their overall results, the authors offered this observation: “In practical terms, the whole concept of hedge fund investing can be justified if hedge funds fulfill two conditions. First, the strategies they employ are beyond the capabilities of unsophisticated investors; i.e., they cannot be easily implemented by investors. Second, and more important, these strategies generate positive incremental value to investors.”

However, they determined that while their findings support the first condition, there is little evidence to confirm that these nonlinear strategies, over the long term, deliver positive performance.

The authors reached the conclusion that their results provided “evidence against hedge fund managers’ claims of skill leading to superior returns.” They state: “Consistent with the notion of efficient markets removing abnormal profits, our results suggest that most hedge funds are ‘passive’ and generate returns consistent with linear risk factor exposures.”

This commentary originally appeared September 8 on ETF.com

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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2015, The BAM ALLIANCE

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Chief Research Officer

Larry Swedroe is Chief Research Officer for the BAM ALLIANCE.

Previously, Larry was vice chairman of Prudential Home Mortgage. Larry holds an MBA in finance and investment from NYU, and a bachelor’s degree in finance from Baruch College.

To help inform investors about the evidence-based investing approach, he was among the first authors to publish a book that explained evidence-based investing in layman’s terms — The Only Guide to a Winning Investment Strategy You’ll Ever Need. He has authored 15 more books:

What Wall Street Doesn’t Want You to Know (2001)
Rational Investing in Irrational Times (2002)
The Successful Investor Today (2003)
Wise Investing Made Simple (2007)
Wise Investing Made Simpler (2010)
The Quest for Alpha (2011)
Think, Act and Invest Like Warren Buffett (2012)
The Incredible Shrinking Alpha (2015)
Your Complete Guide to Factor-Based Investing (2016)
Reducing the Risk of Black Swans (2018)
Your Complete Guide to a Successful & Secure Retirement (2019)

He also co-authored four books: The Only Guide to a Winning Bond Strategy You’ll Ever Need (2006), The Only Guide to Alternative Investments You’ll Ever Need (2008), The Only Guide You’ll Ever Need for the Right Financial Plan (2010) and Investment Mistakes Even Smart Investors Make and How to Avoid Them (2012). Larry also writes blogs for MutualFunds.com and Index Investor Corner on ETF.com.

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