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Factor Timing among Hedge Fund Managers

Posted in Investing Expertise, Mutual/Hedge Funds

Can hedge fund managers reliably time eight factors explaining multi-class asset returns: equity market; size; bond market; credit spread; trend-following for bonds, currencies and commodities; and, emerging markets? In their July 2016 paper entitled “Timing is Money: The Factor Timing Ability of Hedge Fund Managers”, Bart Osinga, Marc Schauten and Remco Zwinkels study the magnitude, determinants and persistence of factor timing ability among hedge fund managers. To minimize biases, they: include live and dead funds; remove the first 18 months of returns for each fund; consider only funds that have at least 36 monthly returns and average assets under management $10 million; and, consider only funds that report net monthly excess returns in U.S. dollars. They also exclude the top and bottom 1% of all returns to suppress outlier effects. Using monthly returns for 2,132 dead and 992 live hedge funds encompassing nine investment styles, and contemporaneous factor returns, during January 1994 through April 2014, they find that:

  • The average monthly return of all sampled funds is 0.64% (7.72% annualized), with monthly standard deviation 3.82% and maximum (minimum) monthly return (20.6%) (-19.5%).
  • There is factor timing ability among hedge fund managers in aggregate, but skill varies by factor and fund characteristics. Overall factor timing skill appears unrelated to investment style.
    • Timing skill is strongest overall for market, size and bond factors and weakest (substantially negative) for the emerging markets factor, but level of skill varies across investment styles.
    • Funds that are young, small, costly (high incentive fees), flexible (short restriction period) and leveraged tend to exhibit the greatest overall timing skill, but determinants vary across factors.
  • An equally weighted portfolio of funds that is each month long (short) the tenth of funds exhibiting the best (worst) factor timing ability over the past 36 months generates 0.6% monthly alpha (about 1% annually) relative to the eight factors over the sample period. This alpha comprises 13% of overall hedge fund performance persistence, suggesting that asset selection skill accounts for 87%.
  • Findings are robust to alternative factors, factor model adjustments and controls for fund use of derivatives, public information and fund size.

In summary, evidence indicates that hedge fund managers overall generate about 1% per year benefit for investors by successfully timing factor exposures.

Cautions regarding findings include:

  • Exploiting hedge fund performance persistence as described is problematic because most investors cannot hold enough funds for statistical reliability. Further, investors may not be able to enter and exit funds in a timely manner (monthly, as specified). In other words, the 1% annual alpha of hedge fund factor timing may not be practically accessible.
  • In parsing skill analyses by fund type and factor, the study appears not to take into account data snooping bias (by strengthening statistical reliability tests), thereby overstating reliability of parsed findings.
  • The authors do not investigate whether hedge fund manager factor timing skill changes over time.
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