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Hedge Fund Success: Timing or Stock Picking?

| | Posted in: Mutual/Hedge Funds

Do equity hedge fund managers achieve positive alpha by timing the market or by picking (for or against) the right stocks? In their July 2006 paper entitled “How Hedge Funds Beat the Market”, Craig French and Damian Ko investigate the degrees to which these two potential sources of excess returns contribute to market outperformance by hedge fund managers. Using monthly returns for a sample of 157 long-short equity hedge funds reporting over the entire period 1996-2005, they conclude that:

Before adjusting for the illiquidity of hedge funds:

  • Almost all funds exhibit outperformance based on stock picking, with two thirds statistically significant.
  • Only 2% exhibit statistically significant outperformance based on market timing, while 11% exhibit statistically significant lack of outperformance based on market timing.

After adjusting for the illiquidity of hedge funds (thereby reducing average alpha):

  • Almost all funds exhibit outperformance based on stock picking, with one third statistically significant.
  • No hedge funds show statistically significant outperformance based on market timing.

The following topographical map, taken from the paper, shows the distribution of the 157 hedge funds in the sample according to annual returns from 1996 through 2005. About 78% of all returns are positive. During the bear market of 2000-2002, most hedge funds in the sample beat the S&P 500 index returns (white dots). In the preceding and subsequent bull markets, hedge fund returns are distributed around the S&P 500 index returns.

In summary, equity hedge funds generate alpha by stock picking, not market timing.

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