Board of Governors of the Federal Reserve System
International Finance Discussion Papers
Returns to Active Management: The Case of Hedge Funds
Maziar Kazemi and Ergys Islamaj
August 8, 2014
Do more active hedge fund managers generate higher returns than their less active peers?
We attempt to answer this question. Using Kalman Filter techniques, we estimate the risk exposure dynamics of a large sample of live and dead equity long-short hedge funds. These estimates are then used to develop a measure of activeness for each hedge fund. Our results show that there exists a nonlinear relationship between activeness and performance. Using raw returns as a measure of performance, it is found that more active funds outperform the less active ones. However, when risk adjusted returns are used to measure performance, we find the opposite results; that is, activeness is inversely related to returns. Still, we find that a few very active hedge fund managers outperform the moderately active funds and generate higher returns. We conclude that the most active hedge fund managers use their skills to manage the riskiness of their portfolios and are, therefore, able to provide higher risk adjusted returns. Finally, we find that compared to the least active managers, the most active managers are less homogeneous and, therefore, due diligence is far more important when selecting an active manager.
Active Hedge Fund Managers Returns vs Passive Managers Profits – Introduction
Can managers?behavior predict returns in hedge funds? Since 1997, the hedge fund industry?s assets under management (AUM) have increased by more than 14 times, with the AUM growing at an average pace of $100bn per year.1 Hedge funds present themselves as absolute return investment vehicles, seeking to generate positive returns in any market condition. They can take short positions and are not subject to the strict mandates that govern mutual funds. Having such freedom in implementing investment strategies emphasizes the importance of the hedge fund manager?s investment skills. Further, unlike the mutual fund industry, hedge funds charge both management and incentive fees, where the incentive fees provide option-like returns to managers.2. Given its loose investment mandate and fee structure, the hedge fund industry is expected to attract the most skilled asset managers.
This paper investigates whether more active hedge fund managers perform better than those who are less active. Using a sample of 2,687 live and dead equity long-short hedge funds, the Kalman Filter is employed to estimate the risk exposure dynamics of each hedge fund, which then are used to create a measure of activeness for each fund.4 This will allow us to study the relationship between activeness and performance.
A priori, it is not clear whether the after-fee performance of the more active funds should exceed those of the less active funds. Fund managers that have skills in security selection may follow a buy-and-hold approach, while those who have skills in timing various segments of the market may follow a more active strategy. However, if both active and less active fund managers are equally skilled, or if markets are efficient, then because of the transaction costs, we should expect to see lower performance on the part of the active hedge fund managers.
Our primary ?finding is that there exists a nonlinear relationship between activeness and performance, and that the relationship changes depending on whether raw returns or risk-
adjusted returns are used to measure performance. In general, the moderately active funds tend to provide higher mean returns than the less active funds. But as the level of activeness increases, the mean returns tend to decline. When risk adjusted returns are used to measure performance, we find the opposite results. That is, the less active funds perform better than the more active ones, but as the level of activeness increase, the risk-adjusted returns tend to increase. We may conclude that the highly active funds use their skills to manage the riskiness of their portfolios, improving the risk-return problems of their funds. But it is less clear why, on a risk-adjusted basis, the less active funds can perform better than the moderately active funds when they underperform them in terms of raw returns. One can argue that the less active funds are long-term stock pickers, and, therefore, are able to generate better risk-adjusted performance without frequently changing their portfolios ?risk exposures.
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