The performance persistence of equity long/short hedge funds

Abstract

Studies examining the persistence of hedge fund performance vary greatly in their conclusions owing to different methodologies, databases, investigation periods and performance measures.1 This paper does not consider various approaches to clarify the picture, but, instead, focuses on a particularly flexible one. Every period, hedge funds are sorted into portfolios according to characteristics in the last period, and the portfolios are then tracked for the next period. After the tracking period, the sorting is repeated. This approach has been used in the mutual fund literature by Hendricks et al2 and Carhart,3 among others, and has several advantages. First, portfolio betas may be more stable than betas of individual funds because time-varying betas can offset each other on the portfolio level. This is particularly relevant for hedge funds: as they have fewer restrictions on borrowing, shorting, the use of derivatives and so on, they typically follow highly opportunistic strategies that lead to time-varying risk exposures. Secondly, beta measurement is more precise owing to diversification of idiosyncratic risk and long time series for the portfolio returns. Finally, suppose there is only a very small autocorrelation in fund returns. Given the high return variance, it is difficult to detect this correlation by looking at individual funds. As in the case of momentum strategies, we have to buy a portfolio of last period’s winners, not just one fund, to find persistence.