Hedge Fund Breakdown?

Can investors confidently pick hedge funds that will do well? In their September 2017 paper entitled “Hedge Fund Performance Prediction”, Nicolas Bollen, Juha Joenväärä and Mikko Kauppila examine the forecasting power of 26 hedge fund performance predictors identified in past research. These predictors span five categories: seven broad manager skills; four market timing skills; six systematic risks; four tail risks; and, five incentive metrics. They test the predictors individually and in combinations based on an average of rankings by category and overall. Specifically, for their main tests, they each year:

1. Sort funds into fifths (quintiles) based on one predictor or a combination of predictors as measured over the prior 24 months.
2. Randomly select several funds (baseline 15) from the top quintile to represent a feasible long-only hedge fund portfolio.
3. Hold the selected funds with initial equal weights but no interim rebalancing for one year.
4. Calculate the performance of a succession of such one-year portfolios over the sample period.

They run 1,000 trials for each predictor/combination to obtain a performance distribution. Their benchmark is an 80% allocation to the S&P 500 Total Return Index and a 20% allocation to the Vanguard Total Bond Market Index mutual fund (VBTIX), rebalanced annually. They collect data starting in January 1994 but delete the first 12 months to control for backfill bias (reporting of a successful year after the fact). As a robustness test, they repeat the analysis on two subperiods with break point at the end of February 2009. Using monthly returns after fees and characteristics for a broad sample of hedge funds during January 1995 through December 2016, they find that: (more…)