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Trading Habits of Highly Successful Hedge Fund Managers

Posted in Investing Expertise, Mutual/Hedge Funds

What are the trading behaviors of the best-performing hedge funds? In his June 2013 paper entitled “How do Hedge Fund ‘Stars’ Create Value? Evidence from Their Daily Trades”, Russell Jame uses transaction-level data to investigate the magnitude and source of hedge fund equity trading profits. His sample includes name, equity trade dates (but not non-equity trades, if any), execution prices and transaction costs for 74 hedge funds and 579 other institutions over a 12-year period. He estimates performance by constructing buy and sell portfolios from trades and computing portfolio-level returns over intervals of the next 21, 63, 126 and 252 trading days (emphasizing 252 days as closest to the average holding period of a typical hedge fund). He excludes portfolios with fewer than ten stocks as too noisy. He considers gross return, gross DGTW-adjusted return (return on a stock less the value-weighted return on a benchmark portfolio with the same size, book-to-market and momentum characteristics as the stock) and net DGTW-adjusted return. Using detailed trading data as described during January 1999 through December 2010 and associated stock prices through December 2011, he finds that:

  • Hedge funds generate a significant average gross monthly trading return of 0.52%, but the average gross (net) DGTW-adjusted monthly return is a statistically insignificant 0.42% (0.04%). Over longer holding periods, the average hedge fund return is not significantly different from zero.
  • At a monthly horizon, the average trading performance of other institutions is similar to that of hedge funds. At longer horizons, other institutions trade less profitably than hedge funds.
  • Bootstrap simulations indicate that luck cannot explain the annual performance of the top 10-30% of hedge funds. However, there is no evidence of star traders among other institutional investors.
  • Moreover, hedge funds in the top 30% of past annual trading performance (stars) continue to outperform by 0.25% per month (3% per year) over the next year and by 0.19% per month over the next three years. There is no evidence that poorly performing hedge funds continue to underperform. There is no evidence of performance persistence for other institutional traders.
  • Star hedge funds tend to be short-term contrarians (reversal traders) with small price impacts (patient traders). Their profits concentrate in relatively short holding intervals and more contrarian trades. More than 25% (50%) of their annual outperformance occurs within the first month (quarter) after trades.
  • Performance persistence is significantly stronger for contrarian funds with small price impacts, and is absent for funds that follow momentum strategies or have large price impacts.
  • Star hedge funds tend to:
    • Have lockups and relatively long restriction periods.
    • Be net buyers of growth stocks.
  • Star hedge funds tend not to:
    • Trade more frequently.
    • Trade more profitably prior to earnings announcements.
    • Focus on small, value or illiquid stocks.
    • Take unusual left-tail risk.

The following chart, taken from the paper, shows average net DGTW-adjusted monthly percentage returns of star (top 30%) hedge funds by quarter over the year after trades during 2000-2011. While star hedge funds earn significant trading profits, evidence suggests that hedge fund profits decline over time.

star-hedge-fund-average-monthly-returns

In summary, evidence suggest that star hedge funds profit by both buying and selling temporarily illiquid securities at favorable prices from investors who demand immediacy.

Cautions regarding findings include:

  • As noted in the paper, the hedge fund sample is limited and potentially not representative of the entire universe of hedge funds.
  • As noted above, profitability of even star hedge funds declines over the sample period, perhaps due to elevated competition for alpha.
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