Alpha–beta–churn of equity picks by institutional investors and the robust superiority of hedge funds

Abstract

The empirical literature on investment performance suggests that only hedge funds among institutional investors have delivered consistent superior performance. We examine whether this stylized fact holds when we narrow focus to long-equity holdings. In our sample period of 1997–2006, the long-equity holdings of hedge funds can generate a significant excess return (gross alpha) of 4.1 % per year, which contrasts with modest gross alphas of 0.3–1.8 % per year for other six classes of institutional investors. Given realistic execution and overhead costs, only hedge funds are likely to realize net excess returns from equity picking. Among small hedge funds, those with high churn rate show significant positive alphas but those with low churn rates don’t. Greatest superiority is associated with hedge funds with both high churn rate and high deviation from benchmark weights (high active share). Compared to other institutional investors, hedge funds load negatively on an illiquidity factor, which coheres with their higher churn since the latter would imply burdensome trading costs if executed with illiquid stocks. Hedge funds, uniquely among institutional investors, display superior timing of their loading on the market risk factor, and their superior stock-picking alpha persists across the three eras in our sample period.