Value from hedge funds - convexity! - Unfortunately, many don't have it

What is the value of hedge funds - convexity! Let me say it again, convexity. The ability to provide non-linear pay-offs to key market factors. Hedge fund managers show skill when they are able to change their exposures based on the set of linear factor opportunities. However, measuring this skill is not easy. Markets are competitive and highly efficient, so not everyone has skill.

A recent research paper called "Passive Hedge Funds" takes a provocative approach to describing and measuring hedge fund performance using non-linear regression techniques. Skill should be the ability to increase returns through active management in a manner that is better than just having linear exposures to risk factors. For example, a manger that has sensitivity to a linear commodity risk factor should do better than the "beta" in up markets and not lose as much in down markets. If a manager just has a linear exposure to that factor, he is more of a passive manager. Having passive exposure may not be bad, but it may not be skill-based.

The authors argue that most hedge fund managers are passive to some linear factors and hence do not have any skill. These managers do not have skill as defined by the nonlinear exposure to systematic risk factors. I will call this skill, convexity to a linear factor. 2/3rds of hedge fund managers have linear returns tied to well-defined factors. Hence, these are passive managers in that investors could form similar portfolios through combining these linear factors. These managers do not do better than passive exposure. Nevertheless, there are differences in hedge fund style behavior.

Here are three example of risk exposure for different hedge fund styles and their non-linearities or convexities. For managed futures, there is positive convexity with respect to the dollar, commodities, bonds and emerging markets. This is consistent with their broad exposure across asset classes and their focus on long/short trend-following.

The global macro style shows a very different convexity profile with negative convexity to volatility and the dollar.

Fund of funds have a native convexity profile to bonds and credit which is consistent with relative value trading.

This is a very dense piece of research with analysis of hedge funds styles, individual hedge funds, and out of sample performance. The conclusion is what you should expect. Hedge fund styles differ with their linear exposure to risk factors and it is is hard to show skill. Perhaps only one out of five show skill and the even the quality of that skill is dynamic. Managers may have it and then show more linear performance over time. The ability to measure or find skill out of sample is weak. Perhaps trading is so active that a rolling sample of behavior does not fully capture skill behavior. In fact, by the authors measure, the managers that show linear risk exposure perform out of sample quite well relative to those that have non-linear behavior

Do not assume that all hedge fund managers are special or the best of the best. Skill analysis through due diligence is necessary. All hedge fund styles are not alike, and not all hedge fund managers are skillful within their style.