The study found that just one in five funds produced non-linear exposure to the wide variety of “factors”, or return drivers, which were analyzed. As the ability to generate a return that’s independent of what is happening in the market is a measure of skill, this undermines arguments for the value of hedge funds.
Arbitrage, event-driven, and managed future fund styles proved the most likely to be generating non-linear risk exposures, the study showed.
To be sure, this doesn’t mean that hedge funds are just taking a buy-and-hold approach. We simply can’t know based on this study. It is also true that earlier studies have found conflicting evidence of skill-driven returns among hedge funds.
Better Off Passive?
The question of whether hedge funds are generating returns that don’t have a linear relationship with the underlying market forces is not the end of the story. Unfortunately, the study found that the smaller group of hedge funds which are generating non-linear returns is actually getting beaten by those which are, more or less, expensive closet index funds.
There was also a marked tendency among those funds which showed skill to drift toward a more passive profile over time. Just 15 to 25 percent of those who did show skill stayed that way, with the remainder moving toward the pack.
Those skilled funds also demonstrated higher risk of large losses. While the study did not prove this, it seems possible that hedge funds start out taking considerable and genuinely non-linear risks in an effort to distinguish themselves and win clients. That would explain the risk of large losses.
Once money has flowed into the fund, trimming the sails might seem prudent, even if it isn’t what clients think they are paying for. That results in the drift toward the passive category. Interesting too that linear, or passive, funds have a higher chance of staying that way than skilled ones of becoming passive.
“While in the short term hedge funds may engage in dynamic trading strategies involving complex securities, over the long run many of them behave like alternative beta portfolios,” the authors write.
Many industry advocates will doubtless argue that hedge funds aren’t an asset class, and that further, the issue isn’t buying a typical one but one that actually does outperform.