Hedge fund managers are failing to do what they are meant to do: generate outperformance through active management.
According to a paper written by Mikhail Tupitsyn and Paul Lajbcygier of Australia’s Monash University, most hedge funds are actually passive and not too different from alternative beta strategies.
“While in the short term hedge funds may engage in dynamic trading strategies involving complex securities, over the long run many of them behave like alternative beta portfolios.”Specifically, only one-fifth of more than 5,500 hedge funds from 1994 to 2010 had nonlinear exposures to risk factors that drive hedge funds returns, the study found.
An overwhelming two-thirds of the funds exhibited only linear risk exposures—or were passive.
“These results mean that while in the short term hedge funds may engage in dynamic trading strategies involving complex securities, over the long run many of them behave like alternative beta portfolios,” the authors wrote.
Of the different styles of hedge funds, arbitrage, event-driven strategies, and managed futures were the most likely to have nonlinear risk exposures, according to the study.
On the other hand, directional styles—long-short equity, dedicated short bias, and emerging market funds—were mostly passive.
Furthermore, the study found nonlinear funds on average underperformed their not-so-active counterparts.
From 1995 to 2009, the study found nonlinear funds’ returns were 0.1% lower than those of linear funds. They performed even more poorly compared to market-neutral funds, falling 0.28% lower while featuring higher volatility.
These more active hedge funds also had higher negative tail risk and lower Sharpe ratio and alpha than linear funds, the authors added.
In addition, only 15% to 25% of hedge funds and managers that exhibited true skill remained that way over the long term, the paper said, as they failed to withstand poor performance.
“After suffering poor performance compared to linear funds, some of the nonlinear funds do not survive and close down, while others alter their risk profile and become linear funds in order to remain competitive and attract assets under management,” Tupitsyn and Lajbcygier wrote.
Some 40% of nonlinear funds from 1994 to 1998 transitioned over to the passive side in the period between 1999 and 2003.
In comparison, the study found 70% to 85% of passive funds remained passive.
Read the full paper, “Passive Hedge Funds”.