What hedge fund characteristics are most indicative of performance persistence? In the July 2010 version of their paper entitled “Hedge Fund Characteristics and Performance Persistence”, Manuel Ammann, Otto Huber and Markus Schmid investigate hedge fund performance persistence over future horizons of six to 36 months based on portfolios of hedge funds formed via double sorts on past performance and another fund characteristic. The other fund characteristics they consider are: size; age; relative funds flow; closure to new investments; length of withdrawal notice period; length of redemption period; management and incentive fees; leverage; management personal investment; and, a Strategy Distinctiveness Index (SDI) defined as a strategy-normalized form (ten different strategy types) of one minus the R-squared of monthly returns regressed against an equally-weighted strategy index over the prior two years. Using characteristics and groomed performance data for a broad sample of hedge funds over the period 1994-2008, they find that:
- Based on past performance alone:
- Persistence of raw returns is economically meaningful up to two years (but statistically significant only for six months).
- Persistence of multi-factor alpha is both economically and statistically highly significant up to three years. The difference in monthly future alpha between the top and bottom fifths (quintiles) of past alpha is 2.8%, 2.3%, 1.6% and 1.0% for rebalancing frequencies of six months, one year, two years and three years, respectively.
- Based on double sorts that divide each past alpha quintile into a high and low half for some other fund characteristic, SDI is the only characteristic that systematically improves prediction of future performance.
- The difference in monthly alpha between the tenth of funds with highest past alpha and higher SDI and the tenth of funds with the lowest past alpha and lower SDI is 3.0%, 2.6%, 1.8% and 1.0% for rebalancing frequencies of six months, one year, two years and three years, respectively.
- These results translate to annualized alpha improvements of about 4.0% and 2.3% for annual and biennial rebalancing, respectively.
- Results are robust to different factor models for calculating alpha, changing the order of double sorts, different demarcations for initial sorts (fifths, fourths, thirds, halves) and alternative definitions for SDI. However, the prediction enhancement of SDI disappears during the 2008 credit crisis, indicating that high-SDI funds have large idiosyncratic risks exposed by crises.
In summary, evidence indicates that hedge fund investors should focus on funds with the best past performances and the most distinctive (uncorrelated) strategies.
