Hostname: page-component-6d856f89d9-26vmc Total loading time: 0 Render date: 2024-07-16T06:44:24.282Z Has data issue: false hasContentIssue false
  • English
  • Français

Hedge Funds: The Good, the Bad, and the Lucky

Published online by Cambridge University Press:  18 May 2017

Yong Chen ,
Michael Cliff  and
Haibei Zhao
Get access Rights & Permissions [Opens in a new window]

Abstract

We develop an estimation approach based on a modified expectation-maximization (EM) algorithm and a mixture of normal distributions associated with skill groups to assess performance in hedge funds. By allowing luck to affect both skilled and unskilled funds, we estimate the number of skill groups, the fraction of funds from each group, and the mean and variability of skill within each group. For each individual fund, we propose a performance measure combining the fund’s estimated alpha with the cross-sectional distribution of fund skill. In out-of-sample tests, an investment strategy using our performance measure outperforms those using estimated alpha and t-statistic.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 52 , Issue 3 , June 2017 , pp. 1081 - 1109
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2017 

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

Footnotes

1

We are grateful to Stephen Brown (the editor) and Olivier Scaillet (the referee) for constructive suggestions that substantially improved the paper. For helpful comments and discussions, we thank Vikas Agarwal, Charles Cao, Heber Farnsworth, Wayne Ferson, Will Goetzmann, Feng Guo, Michael Halling, Petri Jylha, Greg Kadlec, Andrew Karolyi, Robert Kieschnick, Bing Liang, Andrew Lo, Hugues Pirotte, Jeffrey Pontiff, Zheng Sun, Josef Zechner, Harold Zhang, and seminar and conference participants at Cornerstone Research, the Institute for Quantitative Asset Management (IQAM), Pennsylvania State University, Shanghai University of Finance and Economics, Texas A&M University, the University of North Carolina at Chapel Hill, the University of Texas at Dallas, the University of Virginia, Vienna University of Economics and Business, Virginia Tech, VU University Amsterdam, FBE 654 Asset Pricing class at the University of Southern California, the 2012 NYSE/Euronext Hedge Fund Conference in Paris, and the 2015 Financial Intermediation Research Society Conference. The paper was previously circulated under the title “Hedge Funds: The Good, the (Not-So) Bad, and the Ugly.” All remaining errors are ours alone. The views expressed in this article do not necessarily represent those of Analysis Group, Inc.

References

Ackermann, C.; McEnally, R.; and Ravenscraft, D.. “The Performance of Hedge Funds: Risk, Return, and Incentives.” Journal of Finance, 54 (1999), 833–974.Google Scholar
Agarwal, V.; Daniel, N.; and Naik, N.. “Role of Managerial Incentives and Discretion in Hedge Fund Performance.” Journal of Finance, 64 (2009), 2221–2256.Google Scholar
Agarwal, V., and Naik, N.. “Multi-Period Performance Persistence Analysis of Hedge Funds.” Journal of Financial and Quantitative Analysis, 35 (2000), 327–342.Google Scholar
Agarwal, V., and Naik, N.. “Risk and Portfolio Decisions Involving Hedge Funds.” Review of Financial Studies, 17 (2004), 63–98.Google Scholar
Aragon, G.“Share Restrictions and Asset Pricing: Evidence from the Hedge Fund Industry.” Journal of Financial Economics, 83 (2007), 33–58.Google Scholar
Asness, C.; Krail, R.; and Liew, J.. “Do Hedge Funds Hedge?” Journal of Portfolio Management, 28 (2001), 6–19.Google Scholar
Asquith, D.; Jones, J.; and Kieschnick, R.. “Evidence on Price Stabilization and Underpricing in Early IPO Returns.” Journal of Finance, 53 (1998), 1759–1773.Google Scholar
Bajgrowicz, P., and Scaillet, O.. “Technical Trading Revisited: Persistence Tests, Transaction Costs, and False Discoveries.” Journal of Financial Economics, 106 (2012), 473–491.Google Scholar
Bajgrowicz, P.; Scaillet, O.; and Treccani, A.. “Jumps in High-Frequency Data: Spurious Detections, Dynamics, and News.” Management Science, 62 (2015), 2198–2217.Google Scholar
Barras, L.; Scaillet, O.; and Wermers, R.. “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas.” Journal of Finance, 65 (2010), 179–216.Google Scholar
Brown, S., and Goetzmann, W.. “Mutual Fund Styles.” Journal of Financial Economics, 43 (1997), 373–399.Google Scholar
Brown, S.; Goetzmann, W.; and Ibbotson, R.. “Offshore Hedge Funds: Survival and Performance, 1989–95.” Journal of Business, 72 (1999), 91–117.Google Scholar
Brown, S.; Goetzmann, W.; Ibbotson, R.; and Ross, S.. “Survivorship Bias in Performance Studies.” Review of Financial Studies, 5 (1992), 553–580.Google Scholar
Brown, S.; Gregoriou, G.; and Pascalau, R.. “Diversification in Funds of Hedge Funds: Is It Possible to Overdiversify?” Review of Asset Pricing Studies, 2 (2012), 89–110.Google Scholar
Cao, C.; Chen, Y.; Liang, B.; and Lo, A.. “Can Hedge Funds Time Market Liquidity?” Journal of Financial Economics, 109 (2013), 493–516.Google Scholar
Chen, Y.“Timing Ability in the Focus Market of Hedge Funds.” Journal of Investment Management, 5 (2007), 66–98.Google Scholar
Chen, Y.“Derivatives Use and Risk Taking: Evidence from the Hedge Fund Industry.” Journal of Financial and Quantitative Analysis, 46 (2011), 1073–1106.Google Scholar
Chen, Y., and Liang, B.. “Do Market Timing Hedge Funds Time the Market?” Journal of Financial and Quantitative Analysis, 42 (2007), 827–856.Google Scholar
Criton, G., and Scaillet, O.. “Hedge Fund Managers: Luck and Dynamic Assessment.” Bankers, Markets & Investors, 129 (2014), 1–15.Google Scholar
Dempster, A.; Laird, N.; and Rubin, D.. “Maximum Likelihood from Incomplete Data via the EM Algorithm.” Journal of the Royal Statistical Society Series B, 39 (1977), 1–38.Google Scholar
Evans, R.“Mutual Fund Incubation.” Journal of Finance, 65 (2010), 1581–1611.Google Scholar
Fama, E., and French, K.. “Luck versus Skill in the Cross-Section of Mutual Fund Returns.” Journal of Finance, 65 (2010), 1915–1947.Google Scholar
Ferson, W., and Chen, Y.. “How Many Good and Bad Fund Managers Are There, Really?” Working Paper, University of Southern California and Texas A&M University (2015).Google Scholar
Ferson, W., and Schadt, R.. “Measuring Fund Strategy and Performance in Changing Economic Conditions.” Journal of Finance, 51 (1996), 425–460.Google Scholar
Fung, W., and Hsieh, D.. “Performance Characteristics of Hedge Funds and Commodity Funds: Natural vs. Spurious Biases.” Journal of Financial and Quantitative Analysis, 35 (2000), 291–307.Google Scholar
Fung, W., and Hsieh, D.. “The Risk in Hedge Fund Strategies: Theory and Evidence from Trend Followers.” Review of Financial Studies, 14 (2001), 313–341.Google Scholar
Fung, W., and Hsieh, D.. “Hedge Fund Benchmarks: A Risk-Based Approach.” Financial Analysts Journal, 60 (2004), 65–80.Google Scholar
Getmansky, M.; Liang, B.; Schwarz, C.; and Wermers, R.. “Share Restrictions and Investor Flows in the Hedge Fund Industry.” Working Paper, University of Massachusetts and University of Maryland (2011).Google Scholar
Getmansky, M.; Lo, A.; and Makarov, I.. “An Econometric Model of Serial Correlation and Illiquidity in Hedge Fund Returns.” Journal of Financial Economics, 74 (2004), 529–609.Google Scholar
Goetzmann, W.; Ingersoll, J.; and Ross, S.. “High-Water Marks and Hedge Fund Management Contracts.” Journal of Finance, 58 (2003), 1685–1717.Google Scholar
Griffin, J., and Xu, J.. “How Smart Are the Smart Guys? A Unique View from Hedge Fund Stock Holdings.” Review of Financial Studies, 22 (2009), 2531–2570.Google Scholar
Harvey, C.; Liu, Y.; and Zhu, H.. “…and the Cross-Section of Expected Returns.” Review of Financial Studies, 29 (2016), 5–68.CrossRefGoogle Scholar
Jagannathan, R.; Malakhov, A.; and Novikov, D.. “Do Hot Hands Exist among Hedge Fund Managers? An Empirical Evaluation.” Journal of Finance, 65 (2010), 217–255.Google Scholar
Jones, C., and Shanken, J.. “Mutual Fund Performance with Learning across Funds.” Journal of Financial Economics, 78 (2005), 507–552.Google Scholar
Kon, S.“Models of Stock Returns: A Comparison.” Journal of Finance, 39 (1984), 147–165.Google Scholar
Kosowski, R.; Naik, N.; and Teo, M.. “Do Hedge Funds Deliver Alpha? A Bayesian and Bootstrap Analysis.” Journal of Financial Economics, 84 (2007), 229–264.Google Scholar
Kosowski, R.; Timmermann, A.; White, H.; and Wermers, R.. “Can Mutual Fund ‘Stars’ Really Pick Stocks? New Evidence from a Bootstrap Analysis.” Journal of Finance, 61 (2006), 2551–2595.Google Scholar
Liang, B.“On the Performance of Hedge Funds.” Financial Analysts Journal, 55 (1999), 72–85.Google Scholar
Liang, B.“Hedge Funds: The Living and the Dead.” Journal of Financial and Quantitative Analysis, 35 (2000), 309–326.Google Scholar
Louis, T.“Finding the Observed Information Matrix When Using the EM Algorithm.” Journal of the Royal Statistical Society, 44 (1982), 226–233.Google Scholar
McLachlan, G., and Krishnan, T.. The EM Algorithm and Extensions, 2nd ed. New York, NY: John Wiley & Sons (2008).Google Scholar
McLachlan, G., and Peel, D.. Finite Mixture Models. New York, NY: John Wiley & Sons (2000).Google Scholar
Newey, W., and West, K.. “A Simple, Positive Semi-Definite, Heteroskedasticity and Autocorrelation Consistent Covariance Matrix.” Econometrica, 55 (1987), 703–708.Google Scholar
Rudd, P.“Extensions of Estimation Methods Using the EM Algorithm.” Journal of Econometrics, 49 (1991), 305–341.Google Scholar
Scholes, M., and Williams, J.. “Estimating Betas from Nonsynchronous Data.” Journal of Financial Economics, 5 (1977), 309–328.Google Scholar
Schwarz, G.“Estimating the Dimension of a Model.” Annals of Statistics, 6 (1978), 461–464.Google Scholar
Sirri, E., and Tufano, P.. “Costly Search and Mutual Fund Flows.” Journal of Finance, 53 (1998), 1589–1622.Google Scholar
Sun, Z.; Wang, A.; and Zheng, L.. “The Road Less Traveled: Strategy Distinctiveness and Hedge Fund Performance.” Review of Financial Studies, 25 (2012), 96–143.Google Scholar
Titman, S., and Tiu, C.. “Do the Best Hedge Funds Hedge?” Review of Financial Studies, 24 (2011), 123–168.Google Scholar
Wu, C. F. J.“On the Convergence Properties of the EM Algorithm.” Annals of Statistics, 11 (1983), 95–103.Google Scholar