Why Size Isn’t Everything
Hedge fund survivor bias is especially insidious for the largest firms. Large hedge fund survivor bias overstates expected performance of the biggest firms by nearly half and their risk adjusted return from security selection (stock picking) by 80%. It is impossible to predict the largest funds of the future, but one doesn’t have to – robust skill analytics identify funds that will do even better in the future than tomorrow’s largest.Past Performance of Today’s Largest Hedge Funds
We follow the approach of our earlier piece on hedge fund survivor (survivorship) bias, which analyzed firms’ long U.S. equity portfolios (HF Aggregate). This dataset spans the long portfolios of all hedge funds active over the past 10 years that are tractable using 13F filings. We compare group returns to Factor Portfolio – a portfolio with matching factor (systematic) risk. Factor Portfolio captures the return of investing passively in ETFs and index futures with the same risk as the group. This comparison reveals security selection (stock picking) performance, or αReturn – outperformance relative to the Factor Portfolio and the return that would have been generated if markets had been flat. The following chart compares the performance of the 20 largest U.S. equity hedge fund long portfolios (Large HFs, green) to the Factor Portfolio (black). The security selection performance, or αReturn (blue), is the difference between the two. This is the average past performance of the 20 largest funds of 2015:
Returns (%) |
||
Annualized |
10-year Cum. |
|
Total |
11.48 |
215.26 |
Factor |
9.33 |
154.29 |
Total – Factor |
2.15 |
60.97 |
Future Performance of Yesterday’s Largest Hedge Funds
Most billionaire and guru-following strategies make the assumption that the largest funds are likely to continue generating strong returns. To test this, we tracked the 20 largest long U.S. equity hedge fund portfolios of 2005. Below is the unappealing picture of their average performance:
Returns (%) |
||
Annualized |
10-year Cum. |
|
Total |
7.70 |
116.05 |
Factor |
8.68 |
138.11 |
Total – Factor |
-0.97 |
-22.05 |
Predicting Top Future Hedge Funds: Stock Picking Skill
Absent a time machine, investors cannot know who will be the future stars. However, they need not despair. Instead of focusing on the largest or top-performing funds of the past, they can turn to those showing the highest evidence of skill. The following chart tracks the long U.S. equity portfolios of 20 hedge funds with the highest 3-year αReturn as of 12/31/2005:
Returns (%) |
||
Annualized |
10-year Cum. |
|
Total |
12.60 |
252.58 |
Factor |
9.11 |
148.70 |
Total – Factor |
3.49 |
103.88 |
Conclusions
- Hedge fund survivor bias is larger for the largest hedge funds.
- Between 2005 and 2015, large hedge fund survivor bias overstated expected nominal performance by nearly 100% and security selection performance by 80%.
- Chasing large hedge funds is unnecessary and detrimental. Selecting a fund using robust skill analytics, as illustrated by αReturn, is superior to flawed results hampered by large hedge fund survivor bias.