Alpha Trumps Absolute Return in Hedge Fund Selection

Many investors lured by recent performance

In most longer evaluation windows, “loser” portfolios tend to outperform winners. In most longer evaluation windows, “loser” portfolios tend to outperform winners.

Many investors just can’t help themselves. When hiring hedge fund managers, they are drawn to those that have recently produced outsize returns.

This is understandable, but in the long run, these investors may be doing themselves no favor, according to a white paper released Wednesday by Commonfund.

Allocating to top-performing hedge funds appears to be an effective portfolio strategy within certain short-term windows, but it is typically ineffective in the longer windows that allocators generally use to evaluate managers, the report found.

In fact, in most longer evaluation windows, “loser” portfolios tend to outperform winners.

The white paper reports the results of an experiment whose results showed potential long-term consequences of different selection strategies.

The findings caution against the practice of chasing winners. For most hedge fund investors, frequent and repeated manager turnover is neither a practical nor desirable approach to managing a hedge fund portfolio.

The experiment results also suggest that alpha — return not accounted for by beta to the broad equity market, including from manager skill — consistently outperforms absolute return as a manager selection criterion.

Selection strategies based on alpha offset the negative effect of chasing winners to a significant degree, and generally outperform random selection.

The Commonfund researchers said hedge fund investors who base their hiring and firing decisions on whether managers have captured a significant portion of the equity market’s upside might benefit by being particularly diligent about identifying beta-driven returns as an equity bull market matures.

Amid a prolonged bull market, hedge fund investors may natural tend to seek out managers that have captured a significant share of the market’s upside, they said.

However, equity upside capture is not common or persistent among hedge fund strategies. Using it as a selection criterion may lead to adverse manager selection.

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Check out Ritholtz to Alt Fund Investors: Beware ‘Negative Alpha’ on ThinkAdvisor.

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