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Overall Findings from a Decade of Hedge Fund Research

Posted in Mutual/Hedge Funds

What are the principal themes of research on hedge funds published in top journals over the past decade? In their August 2015 paper entitled “Hedge Funds: A Survey of the Academic Literature”, Vikas Agarwal, Kevin Mullally and Narayan Naik summarize 121 papers on hedge funds and commodity trading advisors from four leading finance journals. They focus on the 105 papers published since 2005. They organize this research into five categories:

  1. Fund performance over time and by type, including return drivers, risks and assessment of manager skill.
  2. Relationships between fund characteristics (such as contractual terms, size, age and manager background) and fund performance.
  3. Investor risks, including manager incentives and capital flows.
  4. Role of hedge funds in the financial system.
  5. Biases in and limitations of data.

Based on this review, they conclude that:

  • Regarding hedge fund performance:
    • Hedge funds have outperformed mutual funds and some asset classes even after accounting for data biases.
    • It is difficult to isolate the effects of specific return drivers (risk factors) because: (1) there are many factors; (2) sample periods are relatively short; and, (3) factors are interrelated.
    • Some managers demonstrate investment skill.
    • Funds of hedge funds add value by mitigating fund selection risk, especially for smaller investors.
  • Regarding relationships of hedge fund characteristics to performance:
    • Managers seek to increase fund size even at the expense of fund performance.
    • Evidence that fund growth harms returns is stronger than evidence that smart money drives fund growth.
    • Some managerial characteristics (education and experience) predict future fund performance.
  • Regarding investor risks:
    • Manager risk-taking varies non-linearly with fund valuation, depending on the gaps between current valuation and (1) high water mark and (2) the valuation at which investors exit.
    • Hedge funds exposed to liquidity and tail risks outperform during normal times but crash during crises.
    • During crises, returns across funds are more correlated and the industry as a whole performs poorly.
  • Regarding the role of hedge funds:
    • It is not clear whether hedge funds in aggregate suppress or amplify systemic risks.
    • Private information of fund managers may affect asset pricing, depending on manager incentives, implementation frictions and funding constraints.
    • Hedge funds are a unique source of market liquidity because of: (1) long investment horizons; and, (2) access to derivatives to hedge position risks.
    • Activist funds generally have a positive effect on target firms, and even the industries of target firms.
  • Regarding data biases:
    • Biases include those associated with self-reporting (lack of validation), survivorship, stale prices used in valuation, self-selection (deciding when to start and stop reporting) and backfill of historical data (look-ahead bias) when starting to report.
    • Such biases make conclusions about industry performance difficult, but they have less import for studies of return drivers and risk-taking.

In summary, the body of research on hedge funds suggests that investors should focus on: (1) quality of data used to describe fund performance; (2) experience and education of fund management; and, (3) fund performance during crises.

Cautions regarding conclusions include:

  • As usual in financial markets, research findings are sometimes contradictory.
  • As noted in the paper, hedge fund performance drivers are diverse and sample periods limited, so understanding what works best is difficult.
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