University of Texas finance professor John Griffin and Jin Xu (who works at Roger Ibbotson's Zebra Capital Management) have some bad news for proponents of hedge funds in their new paper How Smart Are the Smart Guys? (tip o' the cap to CXO's blog). After reviewing the quarterly stock holdings of about 300 hedge fund firms against equity mutual funds from 1980 through 2004, the pair found that the hedgies failed to deliver except during the Internet bubble. On average hedge funds outperformed mutual funds by 1.4 percentage points a year, but three-quarters of the outperformance was due solely to 1999 and 2000. The remainder without those years isn't statistically significant. The hedge fund returns are also measured before fees, so after hedge funds greater fees, the outperformance would be even smaller.
The researchers also confirmed the conventional wisdom that hedge fund managers are more active traders, at least on a quarterly basis with median turn over of 102% versus 63% for mutual fund managers. Hedge funds also show a preference for small cap stocks, being overweight stocks in the smallest 60% of the market measured by market cap. Hedge funds holdings are also more in contrast to the composition of market indexes than mutual fund holdings.
They conclude: "We find that the fraction of hedge fund stock ownership and changes in that fraction are not useful for predicting future returns. These findings indicate that hedge fund holdings and trading are not earning positive returns...Hedge funds exhibit no ability to rotate capital between different asset styles at opportune times and their average style selection slightly underperforms mutual funds."
But before you run off to dance on the grave of the $1 trillion hedge fund industry, there is one problem with the study that's worth considering. Because of a bizarre twist of SEC rules that I can't explain, funds are only required to disclose their long positions in equities, not their short positions or other non-equity positions. That means that many of the holdings Griffin and Xu analyzed might not have even been intended to outperform the market. rather, they were part of a hedge strategy that might involve an offsetting short position, options positions or more complicated arbitrage endeavors. The authors offer a not very persuasive rejoinder: this is the best we can do so tough. Or in their words:
"We view this as an acceptable limitation given that equities comprise a substantial sector of the hedge fund industry, the scarcity of evidence on this topic, and the problems mentioned above with self-reported hedge fund returns. Our basic proposition is to investigate if hedge fund managers are in fact better at the basics of picking stocks and sectors than their counterparts in the mutual fund industry."
Deeper in, they provide some statistical analysis by comparing the return of hedge funds implied by the SEC reports to the monthly returns of the same funds listed in industry databases. They find a mean, or average correlation, of 0.55 indicating that over half of the funds' performance is related to the stock holdings. Only about 1 in 12 funds showed negative correlation with their own stock holdings. Then again, they only had enough matching data to review 130 of the 306 funds in the study using this correlation analysis.
As a further defense, Griffin and Xu also attack the usual approach of studying hedge fund performance using the funds' own self-reported return data. They note that there's the usual bias of funds only reporting when they do well and the loss of failed funds from return databases. Also, since many assets held by hedge funds don't trade regularly, the funds themselves provide prices that may be overly-optimistic, out of date or just plain wrong. Third, returns differ for the same fund listed in different databases, providing evidence of manipulation. And finally, hedge fund strategies sometimes rely on taking huge risks that appear to be paying for a long time until suddenly they don't (see Long Term Capital Management, for example).