Allocators to hedge funds should avoid selecting managers purely on recent performance and instead focus on alpha generation, according to research by Commonfund.
The group’s Head of Hedge Fund Research Kristofer Kwait and Director John Delano detailed research into different methods of manager selection in a new white paper titled “Chasing winners: The appeal and the risk”.
The pair wrote: “Managers that may have been cast among a losers heap for failing to ‘see the ball’—that is, for pursuing strategies with beta properties that are out of favour—might very well demonstrate a sort of mean-reversion effect, on average, and subsequently outperform.”
Kwait and Delano constructed a hypothetical portfolio from a universe of 3,300 equity, event-driven, macro, and relative value hedge funds. Every month the pair brought in two new managers with the best track record in absolute performance over the previous 18 months, and sold them once they had been in the portfolio for 18 months.
Over the course of 14 years, to the end of 2013, the portfolio significantly outperformed the average for their hedge fund universe, implying that churning managers could prove a lucrative strategy (although the effect of fees and trading costs was not investigated).
However, Kwait and Delano went on to show that performance dropped significantly if the evaluation and holding periods were extended to three, four, or five years—periods of assessment far closer to that used in institutional investment.
They wrote that “while there is evidence of positive performance persistence in hedge funds”, these windows of performance were too short to be 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”.
However, when Kwait and Delano turned this strategy to focus on alpha generation rather than pure returns over three and four year periods, they discovered “evidence of a statistical benefit of pursuing managers that have produced alpha”.
The pair concluded: “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.”