Hedge Fund Performance and Persistence in Bull and Bear Markets

Abstract

This paper tests the performance of 2894 hedge funds in a time period that encompasses unambiguously bullish and bearish trends whose pivot is commonly set at March 2000. The database proves to be fairly trustable with respect to the most important biases in hedge funds studies, despite the high attrition rate of funds observed in the down market. An original ten-factor composite performance model is applied that achieves very high significance levels. The analysis of performance indicates that most hedge funds significantly outperformed the market during the whole test period, mostly thanks to the bullish subperiod. In contrast, no significant underperformance of individual hedge funds strategies is observed when markets headed south. The analysis of persistence yields very similar results, with most of the predictability being found among middle performers during the bullish period. However, the 'Market Neutral' strategy represents a remarkable exception, as abnormal performance is sustained throughout and significant persistence can be found between the 20% and 69% best performers in this category, probably thanks to an extreme adaptability and a very active investment behaviour.

Hedge fund return specification with errors-in-variables

“…Nonetheless, there appears to be an economically as well as statistically significant difference in the top and bottom alphas for directional funds during the bearish period. This difference is only emphasized when the HME is used, in contrast with the OLS alphas that are insignificant, a finding consistent with those of Capocci et al 4 …”

“…Our database includes a substantially higher number of dead funds ( þ 446) than the MAR database used by Capocci et al, 4 especially for the GES ( þ 97 dead funds), FOF ( þ 77) and MKN ( þ 72) strategies. Consistent with previous studies, some strategies appear to achieve extremely favorable performance for all measures.…”

“…To study the persistence in alphas, we use an approach similar to that of Capocci et al 4 that adapts that originally proposed by Carhart 32 on mutual funds. For the two sub-periods ((01:1994-12:1997) and (07:1996-06:2000)) selected above, we constructed five portfolios for each broad strategy (Directional, Non-Directional and FOF) based on alpha OLS and alpha HME performance.…”

“…The first approach is to relax the assumption of constant exposures to the risk factors. This can be achieved by measuring regime-switching betas, as in the study by Edwards and Caglayan 3 and Capocci et al, 4 who measure different betas in up and down markets, or by allowing for time-varying betas. This approach is advocated by Fung and Hsieh 5 and Posthuma and Van der Sluis 6 in a Kalman filtering approach.…”

The lifecycle of hedge funds

“…Capocci et al 7 find performance persistence predominantly in average or below-average hedge funds. Hence poor performance is a crucial factor in hedge fund mortality.…”