Why are top performing hedge funds successful? Some non-parametric evidence

Top performing hedge funds have skill, but how do they show it? This is not an easy answer when looking at the set of all hedge funds across a wide variety of styles. However, so some researchers have focused on nonparametric analysis through looking at concepts of stochastic dominance. (See Hedge Fund Strategies: A Non-parametric Analysis.) 

Stochastic dominance looks at choice under uncertainty through whether the expected utility received from one hedge will be preferred to another. A non-parametric analysis often focuses on first order (for every expected utility maximizer) or second order (for risk averse utility maximizers) stochastic dominance. Comparison for dominance can be conducted for a large set of hedge fund strategies. Researchers find that top firms have persistence out of sample for months after their value is identified. 

The researchers also find that top performing hedge funds are systematically different from mediocre hedge funds. The researchers find that top performing managers have more market and momentum risk. They also find that top performers accept fewer risk factors which suggest that they may be harder to describe and take more idiosyncratic risks. I am surprised by these results. 

Additionally, top managers seem to anticipate troubling economic conditions and avoid those risk factors tied to negative market conditions. Top managers will avoid illiquid investments and accept market risk when appropriate. They will exploit momentum trading but have the ability to avoid momentum reversal. 

Many of these results are subtle and subject to interpretation, but it seems that the top hedge funds can avoid key risks during troubling times, do a good job of exploiting market risk and the herd through momentum trades, but also know when to get out and not be the last man at the party. More work needs to look at what makes a successful hedge fund. This would should also be more strategy specific.

In the context of today's markets, it seems that top managers will measure extreme sentiment and start to adapt before markets may again turn down. I would not be surprised that the best hedge funds will be reducing exposure to market leaders and starting to reduce risk exposure after a successful second quarter ride.