Market conditions vary considerably across the business cycle, presumably affecting the opportunity set for a given investing style/strategy. What are the return characteristics that predict which hedge funds can best navigate changing economic conditions? In his 2007 paper entitled “The Sustainability of Hedge Fund Performance: New Insights”, Daniel Capocci decomposes hedge fund returns to determine how investors can reliably identify funds that outperform equity and bond indexes in both bull and bear markets. Using monthly return data for the 1994-2002 business cycle from two sources (3,060 individual funds and 907 funds of funds) to investigate 14 potentially useful persistence discriminators, he concludes that:
- Most types of hedge funds outperform equity and bond indexes during the sample period. (Reference the table below.) Some lean toward value, and some toward growth. Many exploit momentum.
- An investor could not outperform major market indexes by switching each year to the previous year’s top hedge funds.
- However, low-volatility funds tend to outperform both other funds and major market indexes consistently and significantly. Measures that effectively incorporate return volatility include Sharpe ratio (higher is better), standard deviation (lower is better) and beta (lower is better).
- An investor could beat the indexes by switching each year to the funds with the best risk-return characteristics over the past three years. However, the difficulty of exiting hedge funds is a substantial barrier to implementing such a strategy, and poor (self-reported) data represents a risk in analyzing hedge funds.
- Results hold across the full market cycle of the entire sample period and in bull and bear subsamples separately.
The following table, excerpted from the paper, summarizes key return statistics across all hedge funds in the sample by fund strategy and in aggregate for 1994-2002. “Dead funds” is the mortality rate of funds for the entire sample period. The last three columns provide the mean return, standard deviation of returns and median return on a monthly basis by fund type. For example, of the 731 market neutral (Mkt ntl) funds in the sample, 64% (468) cease operations during the sample period. These 731 funds generate a mean (median) monthly return of 1.02% (1.00%), with a 1.22% standard deviation of monthly returns. This type has the lowest volatility. Sector funds generate the highest mean monthly returns, but with relatively high volatility.
In summary, low volatility of returns is key to identifying persistent outperformance among hedge funds.
Frequently Asked Questions
What is hedge fund performance persistence?
Hedge fund performance persistence is the tendency of funds that outperform in one period to keep outperforming in later periods. Investors look for return characteristics that identify such funds in advance, including across bull and bear markets. Daniel Capocci's 2007 study tested 14 potential persistence discriminators using 1994-2002 monthly data on 3,060 individual hedge funds and 907 funds of funds.
Do low-volatility hedge funds outperform the market consistently?
Low-volatility hedge funds tend to outperform both other hedge funds and major equity and bond indexes consistently and significantly, according to Capocci's 1994-2002 study of 3,060 funds. The results held over the full market cycle and in bull and bear subsamples separately. Switching each year to the funds with the best risk-return characteristics over the prior three years beat the indexes, whereas switching to the prior year's top-performing funds did not.
How do you identify hedge funds that will keep outperforming?
The study identified persistent hedge fund outperformers by using volatility-sensitive measures: higher Sharpe ratio, lower standard deviation and lower beta. Capocci tested 14 persistence discriminators on monthly return data for 1994-2002, and selected funds each year based on their risk-return characteristics over the past three years. This approach beat major indexes, while ranking on the previous year's raw returns did not.
Are past top-performing hedge funds a better pick than low-volatility hedge funds?
Low-volatility hedge funds were a better pick than past top performers in Capocci's 1994-2002 sample. An investor switching each year to the previous year's best-returning funds could not outperform major market indexes. Funds with strong risk-adjusted profiles (high Sharpe ratio, low standard deviation, low beta) did outperform, and market neutral funds had the lowest volatility at a 1.22% monthly standard deviation, versus sector funds, which had the highest mean returns but relatively high volatility.
What are the risks of choosing hedge funds based on low volatility?
Selecting hedge funds on low volatility faces practical and data limitations: the difficulty of exiting hedge funds is a substantial barrier to implementing an annual switching strategy. Poor, self-reported data also poses a risk when analyzing hedge funds. In addition, fund mortality is high in the sample; for example, 64% (468) of the 731 market neutral funds ceased operations during 1994-2002.