Commonfund today announced the release of the new whitepaper, “Chasing Winners: the Appeal and the Risk” authored by members of its Hedge Fund Strategies Group, Kristofer Kwait, Managing Director, Head of Hedge Fund Research, and John Delano, Director. The paper shows that many hedge fund managers have benefited from outsized gains due to the extended broad market rise. Investors are often influenced strongly to select those hedge fund managers that have produced outsized recent performance. However, this strategy can work against investors in the long run since it is implicitly based on the manager’s ability to track market movements across investment environments — even though evidence for this ability within the manager universe is not robust. This strategy also discounts alpha, which evidence suggests is a better measure for producing long-run results.
Hedge funds management: Key points
In the whitepaper, the authors make the following points:
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- For the large majority of hedge fund investors, frequent and repeated manager turnover is neither a practical nor desirable approach to managing a hedge fund portfolio. However, experiments simulating such an approach can be useful in that they can illustrate potential long-term consequences of different selection strategies.
- The paper presents results of one such experiment that offers a strong caution against the practice of chasing winners, or hiring managers that have had the highest recent returns.
- The experiment results also suggest that alpha – in this case, return not accounted for by beta to the broad equity market, including from manager skill – consistently outperforms absolute return as a manager selection criterion.
- Amid a prolonged bull market, there may be a natural tendency for hedge fund investors to gravitate toward managers that have captured a significant share of the market’s upside. However, since such equity upside capture is not common or persistent among hedge fund strategies, using it as a selection criterion may lead to adverse selection.
Hedge funds play diverse roles in institutional portfolios. Perhaps most commonly, hedge fund mandates carry the broader objective of absolute return: positive return is both the goal for performance and implicitly the basis on which to evaluate individual portfolio line items over time. Investors typically also expect that part of that return will be attributable to alpha. Statistically, alpha is a precise and well-defined measure: the contribution to return after accounting for systematic market risk, as represented by the intercept of a linear equation. In hedge fund vernacular, it is also often taken to represent the somewhat harder to pin down “skill.” Whereas skill is relatively fixed, or is associated with qualities that accrete in a manager over years, alpha is highly time-varying, and fluctuates across windows in which it is measured.For an allocator, that this relationship between observed alpha and skill is not necessarily certain may leave a door open for inferring a sort of skill even from beta-driven returns, perhaps on the basis of a hard to define but powerful argument that a manager is “seeing the ball.”
The Commonfund proprietary evaluation, coupled with a substantial body of research, generally finds that while there is evidence of positive performance persistence in hedge funds, statistically such persistence is confined to short windows. Too short, that is, to form the basis of a realistic investment strategy for the large majority of allocators, most of which would prefer not (or are structurally unable) to manage a hedge fund allocation with continual short-term turnover.
Top-performing hedge funds an effective portfolio strategy
Although hiring top-performing hedge funds appears to be an effective portfolio strategy within certain short time windows, it is typically ineffective in the longer windows which allocators generally use to evaluate managers. In fact, in longer evaluation windows, “loser” portfolios outperform winners. Within the experiment, selection strategies based on alpha – even single-factor alpha to the broad equity market – offset the negative “chasing winners” effect to a significant degree, and generally outperform random selection. It may benefit hedge fund investors (who base hire and fire decisions on whether managers have captured a significant portion of the equity market’s upside) to be particularly diligent about identifying beta-driven returns as an equity bull market turns several years old and consider using alpha as a complementary or alternative measure when evaluating managers.
The whitepaper may be downloaded by clicking here.
Commonfund was founded in 1971 as an independent nonprofit investment firm with a grant from the Ford Foundation. Directly or through its subsidiaries – Commonfund Capital and Commonfund Asset Management Company – Commonfund today manages nearly $25 billion for endowments, foundations and pension funds. Among the pioneers in applying the endowment model of investing to institutional investors, Commonfund provides extensive investment flexibility using independent investment sub-advisers for discretionary outsourcing engagements, single strategies and multi-asset solutions. Investment programs incorporate active and passive strategies in equities and fixed income, hedge funds, commodities and private capital. All securities are distributed through Commonfund Securities, Inc., a member of FINRA. For additional information about Commonfund, please visit www.commonfund.org.