Tuesday, June 14, 2016

Better when returns are down - clear signal of investment skill

The number one issue for any hedge fund investor is measuring manager skill. Everyone has heard that past performance is not indicative of future success, but what can you learn from the past that will help measure future skill? The data are mixed with skin still being elusive.

A new research paper, however,  has some useful insight. (See "Only Winners in Tough Times Repeat: Hedge Fund Performance Persistence Over Different Market Conditions" by Sun, Wang, and Zheng.) Instead of looking at all of the data, the authors conduct conditional tests based on up and down return periods. I am not a great fan of their measure of down markets, but I accept it as a measure that can allow us to review a lot cross-sectional information.

Dividing the market into these up and down returns periods by hedge fund styles, the researchers find that managers who do well when everyone in their peer group is doing poorly is a strong gauge of future returns. Call this the "when the going gets tough, the tough get going" measure. It works. The persistence of this conditional information can last up to three years. It is strong across all hedge fund styles and exists ben when returns are filtered through factor models.

This conditional result makes intuitive sense. We have seen other research results suggests that skilled are real good market timers who avoid market downturns. When hedge fund returns are good there could be a fair number lucky managers because the environment is good for making money. When the hedge fund environment is poor, skill can be truly assessed or measured. The best managers can make money despite the poor environment. In fact, this is when they thrive.

Show me a manager that can beat his peers during rough performance periods and I will show you a manager that I would want in my portfolio.

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