We show that most hedge fund managers are passive, not active. Active management should be manifest through nonlinear exposure to the systematic risk factors that drive hedge fund returns which leads to enhanced performance. However, our findings indicate that approximately two-thirds of hedge funds exhibit only linear factor exposures and hence are ‘passive’. What’s more, such ‘passive’ managers tend to outperform ‘active’ managers. Finally, we also show that many ‘active’ managers, despite initial nonlinear risk exposures, eventually become ‘passive’.
For more sophisticated investors, hedge funds offer a range of complex actively managed strategies (e.g. using leverage, derivatives and short selling) in order to deliver returns that are uncorrelated with movements in traditional asset classes, and the broader market.
Hedge fund managers generally charge higher fees than other investment managers in return for their ability to generate excess returns, or ‘alpha’.
In recent years, however, a number of studies have challenged the notion of hedge funds possessing skill, thereby questioning the value added by hedge funds and whether their high fees are justified.
We conducted our own study to answer the question of whether hedge fund managers generate returns through managerial skill.
According to our findings, the answer is no.
We find that most hedge fund managers are passive not active.
In fact, most hedge fund managers rely on passive market exposures to generate their returns and, paradoxically, these managers tend to outperform most active managers.
Our study analyses the results of 5,580 hedge funds, of which 2,670 are active and 2,910 are now defunct, over the period from January 1994 to September 2010.
Hedge fund skill
To demonstrate genuine investment skill to investors, a hedge fund manager needs to generate enhanced performance through active management.
Active strategies such as market timing, should be evident through nonlinear exposure to the systematic risk factors (or alternative beta) that drive hedge fund returns and lead to outperformance.
This is as opposed to passive, buy and hold strategies providing linear exposure to market returns.
To test for individual manager investment skill, we examine whether hedge fund returns are due to linear or nonlinear exposures to systematic risk factors. And, in our analysis, we consider which risk factors explain various hedge fund styles and the persistence of nonlinear risk exposures in hedge fund performance.
After investigating the prevalence of nonlinear patterns in the risk exposures of individual funds, at the fund level, we find that only around one-fifth of funds exhibit significant active (nonlinear) patterns in risk exposures over the long run.
We find that the majority of funds, roughly two-thirds, exhibit only linear exposures, and are therefore passive.
The rest of the funds have insignificant exposures to any systematic risk factors and are deemed to be market-neutral funds.
This means that while in the short term hedge funds may engage in dynamic trading strategies involving complex securities, over the long run many of them behave like portfolios with passive exposures to systematic risk factors (alternative beta).
Our results also show that when hedge funds are grouped into style portfolios, nonlinear risk exposures are more pronounced in styles that focus on exploiting arbitrage opportunities and relative security mispricing.
Hedge fund performance and persistence of non-linear exposures
Next, we look at whether including nonlinearities leads to enhanced forecasting performance of hedge fund style returns.
In order to evaluate the impact of nonlinear risk exposures on hedge fund performance, we construct three portfolios of funds for each style: a portfolio of exclusively linear exposed funds; another of nonlinear exposed funds; and a portfolio of market-neutral funds.
Here, our results suggest that, on average, nonlinear funds are inferior to linear funds, both in terms of the raw and risk-adjusted returns, and they also have higher negative tail risk.
Overall, the raw returns of nonlinear funds are 0.1% lower than returns of linear funds and 0.28% lower than returns of market-neutral funds, while featuring higher volatility.
The risk-adjusted returns also suggest that overall, nonlinear funds underperform linear and market-neutral funds.
This provides evidence against hedge fund managers’ claims of skill leading to superior returns.
Finally, we also analyse the persistence of hedge funds to risk exposures in an attempt to verify whether performance patterns observed among nonlinear, linear, and market-neutral funds can be exploited by investors to generate profits.
We find that the majority of funds with nonlinear exposure to systematic risk factors that survive over the long term tend to alter their risk exposures and eventually adopt passive exposures to these factors.
What this means for investors
The findings about the poor relative performance of hedge funds with significant exposure to alternative risk factors are important for the debate about fund manager skill and the value added by hedge funds.
In summary, we find that most hedge funds exhibit only linear factor exposures and hence are passive. What’s more, such passive managers tend to outperform active managers with nonlinear exposures.
Our results suggest that, consistent with the notion of efficient markets removing abnormal profits, most hedge funds are passive and generate returns in line with their linear risk factor exposures.
This Working Paper was produced by the CSIRO-Monash Superannuation Research Cluster a collaboration between the CSIRO and Monash University, the University of Western Australia, Griffith University and the University of Warwick in the United Kingdom. In addition, the Cluster engages on an ongoing basis with a range of industry supporters, government agencies and industry peak bodies who assist in providing guidance and feedback to researchers, providing data, and in disseminating outcomes. The purpose of the Super Research Cluster is to examine issues pertaining to the future of Australia’s superannuation and retirement systems.