Do hedge funds systematically exploit the major stock return anomalies? Or, do they earn their keep (if they do) via more arcane strategies? In their January 2008 paper entitled “Do Hedge Funds Arbitrage Market Anomalies?”, Dan Lawson and David Peterson apply a seven-factor model (market, size, value, momentum, earnings momentum, equity financing and asset growth) to investigate whether hedge funds successfully exploit market anomalies. They also examine whether hedge funds generate abnormal returns separately from these “famous” factors. Using detailed data on 1,460 individual hedge funds involving 21 types of strategies and stock return anomaly data for the period 1990-2005, they find that:
- All types of hedge fund strategies have positive average monthly raw returns, most exceeding 1%. The average equal-weighted (value-weighted) monthly raw return for all sample funds across the entire period is 1.16% (1.22%).
- Overall, the seven-factor model works well over the sample period, with an adjusted R-squared statistic of 0.795 (0.622) for equal-weighted (value-weighted) global portfolio excess returns. The market factor is marginally significant, while the size and value factors are not significant. The momentum factor is significant. Earnings momentum, equity financing and asset growth, adjusted for the other four factors, are significant.
- Hedge funds broadly exploit the asset growth anomaly by being long (short) low-growth (high-growth) firms.
- Hedge funds broadly suffer by doing the opposite of what the equity financing anomaly indicates by being long (short) firms with new stock issuances (repurchases).
- Driven by just a few types of hedge funds, the average fund exploits the earnings momentum anomaly by being long (short) firms with high (low) earnings momentum.
- On a strategy-specific basis, hedge funds employing:
- Equity long-only and equity long-bias strategies successfully exploit the earnings momentum anomaly.
- Equity long-short, event-driven, fund timing and convertible arbitrage strategies successfully exploit the asset growth anomaly.
- Large equity short-bias funds suffer by fighting the asset growth anomaly.
- Hedge fund seven-factor alphas (corrected for survivorship bias) tend to be positive and significant, indicating that the industry generates substantial returns from sources other than the major anomalies.
In summary, hedge funds in aggregate exploit a few of the “famous” anomalies, but they apparently have other methods of generating abnormal returns.
