In his recent PhD thesis entitled “An Analysis of Hedge Fund Strategies”, Daniel Capocci offers an epic study of hedge fund properties, results and potential benefits. Specifically, he: (1) applies a multi-factor performance analysis model to determine the degree to which hedge funds persistently produce alpha; (2) measures the extent to which market-neutral hedge funds are really neutral; and, (3) examines the mean, volatility, skewness and kurtosis of hedge fund returns to evaluate their potential benefits to investors. Using hedge fund performance data from several sources spanning 1993-2003, he finds that:
- Depending on the period and strategy considered, 20-50% of individual hedge fund managers outperform traditional indexes.
- The best (worst) performing funds generally follow momentum (contrarian) strategies. Funds with average returns tend toward high book-to-market (value) stocks, whereas those with the best and worst returns tend toward low book-to-market (growth) stocks.
- Hedge funds overall tend to outperform during bull markets, but not during bear markets. Only market-neutral funds outperform during bear markets.
- One third of self-described market-neutral funds are, in fact, significantly exposed to the market. Two-thirds of market neutral funds significantly beat their benchmarks. Among market-neutral funds, those that are truly neutral tend to outperform.
- Funds offering stable mid-range returns, low volatility and limited exposure to stocks consistently and significantly outperform equity and bond markets over both full market cycles and during bull and bear periods.
- Hedge funds are attractive investment tools for almost every investor, but both the types of funds that are appropriate and the size of the allocation to hedge funds depend on specific investor needs.
In summary, hedge funds that conservatively smooth out market bumps with minimal net exposure to equities and mid-range returns tend to be the most reliable outperformers.
With dramatic expansion in the number and size of hedge funds since 2004, outperformance may have become rarer.
