And momentum mutual funds themselves are doing little better than if they followed a naive index-like momentum strategy, adding just 2 basis points of extra return per quarter.
Hedge funds in the study also did a fairly good job of market timing at crucial turning points, according to the findings of the study, again in contrast to mutual funds. Having been “fairly neutral” during much of the run-up in stocks in the dotcom bubble, hedge funds in the study turned strongly contrarian in the second half of 2000. Similarly in the latter stages of the housing bubble, they became far more contrarian between the end of 2006 and end-2008. Mutual funds intensified momentum trades between mid-2007 and mid-2008.
While I am skeptical about the benefits of hedge funds, this study, in using 13F filings, avoids a lot of the common errors of studies based on reported hedge fund returns, such as survivorship, backfill, and self-selection biases.
So where, you may ask, are contrarian hedge funds finding all these bargain stocks to buy?
From mutual funds of course. One possible consequence of a momentum strategy is that you will tend to be a seller of that which is going down. It's also the case that mutual funds, which have to offer daily liquidity to their investors, are thus often forced sellers at times of stress if retail holders get jumpy and want out.
While hedge funds sometimes come undone based on similar dynamics, they will tend to have redemption gates which makes them less likely to be forced to dance at the end of their investors’ strings.
“We also find that hedge funds’ contrarian trading (buying of losers) increased during 2008-2009, while mutual funds’ selling of losers intensified,” the authors write.
They also find that hedge fund outperformance still holds when taking into account transaction costs and other expenses associated with a fund. Hedge funds have higher turnover in their portfolios, costing themselves an estimated 15 basis points a quarter against seven for mutual funds.
One important factor here is that hedge funds are not required to report short sales in the same way as purchases, a factor which may either flatter or underestimate their performance.
The study adds to the weight of evidence that mutual funds are not pulling their weight and offers encouraging hard data about hedge funds.