What proportion of long-short equity hedge fund managers effectively time the stock market? In their January 2013 paper entitled “Hedge Fund Managers’ Market Timing Skills”, Xin Li and Hany Shawky investigate whether long-short equity hedge funds (the oldest and largest hedge fund category) exhibit market timing skill by adjusting positions with market trends. Specifically, they examine hedge fund return correlations with the Fama-French model factors (market, size and book-to-market ratio) during three major crises: the Long-Term Capital Management (LTCM) collapse in the fall of 1998; the quant crisis in August 2007; and, the financial crisis in 2008. They also examine market timing behaviors of individual hedge funds over their respective lifetimes by relating fund beta to market return via a nonlinear function accounting for risk aversion and/or market liquidity. Using monthly returns for 1,571 long-short equity hedge funds having at least 48 months of returns, and contemporaneous Fama-French factor returns, during January 1994 through January 2011, they find that:
- Over the sample period, the average monthly market, size and book-to-market factors for U.S. stocks are 0.52%, 0.23% and 0.28%, respectively. The best (worst) monthly excess market return is 11.0% in April 2009 (-18.6% in October 2008). The second worst is -16.2% in August 1998.
- About a fifth of hedge funds exhibit significantly good overall market timing, with the following overlapping sub-skills:
- 17% exhibit good timing with respect to the market factor.
- 14% exhibit good timing with respect to the size factor.
- 13% exhibit good timing with respect to the book-to-market factor.
- Less than 10% of funds exhibit bad timing with respect to any of the three factors.
- A significant number of funds exhibit contrarian behavior, becoming more conservative (aggressive) when the market return is far above (below) average.
- Funds with good market timing skills generally have less investor-driven liquidity pressure (which may inhibit market timing).
- Measured by average annual return (Jensen’s alpha), good market timers tend to outperform bad market timers by 0.9% (1.5%). Super market timers (successfully timing all three factors) tend to outperform the long-short equity fund average significantly.
In summary, evidence indicates that some hedge funds exhibit market, size and/or book-to-market factor timing skill that translates to fund outperformance.
Cautions regarding findings include:
- Analyses are in-sample, such that an investor may not be able to identify/exploit hedge funds with good timing before the fact. In other words, the study does not address out-of-sample persistence of timing skill.
- While considering the role of luck on an individual fund level, the study does not address the data snooping bias (luck) introduced by testing a large number of strategies (funds) on the same data.
