Do Hedge Funds Deliver Alpha? A Bayesian and Bootstrap Analysis

Using a robust bootstrap procedure, we find that top hedge fund performance cannot be explained by luck, and that hedge fund performance persists at annual horizons. Moreover, we show that Bayesian measures, which help overcome the short-sample problem inherent in hedge fund returns, lead to superior performance predictability. Relative to sorting on OLS alphas, sorting on Bayesian alphas yields a 5.5 percent per year increase in the alpha of the spread between the top and bottom hedge fund deciles. Our results are robust, and relevant to investors, as they are neither confined to small funds, nor driven by incubation bias, backfill bias or serial correlation.

[1]  Sheridan Titman,et al.  On Persistence in Mutual Fund Performance , 1997 .

[2]  R. Stambaugh,et al.  Analyzing Investments Whose Histories Differ in Length , 1997 .

[3]  William N. Goetzmann,et al.  Offshore Hedge Funds: Survival and Performance 1989-1995 , 1997 .

[4]  V. Agarwal,et al.  Risks and Portfolio Decisions Involving Hedge Funds , 2004 .

[5]  E. Mammen.  The Bootstrap and Edgeworth Expansion , 1997 .

[6]  Jeffrey A. Busse,et al.  Bayesian Alphas and Mutual Fund Persistence , 2003 .

[7]  Mark M. Carhart.  On Persistence in Mutual Fund Performance , 1997 .

[8]  Igor Makarov,et al.  An econometric model of serial correlation and illiquidity in hedge fund returns , 2004 .

[9]  V. Agarwal,et al.  Flows, Performance, and Managerial Incentives in the Hedge Fund Industry , 2003 .

[10]  Hong Zhang,et al.  Estimating the Dynamics of Mutual Fund Alphas and Betas , 2004 .

[11]  Stephen E. Wilcox.  Offshore Hedge Funds: Survival and Performance, 1989–95 , 1999 .

[12]  M. Mitchell,et al.  Characteristics of Risk and Return in Risk Arbitrage , 2000 .

[13]  W. Newey,et al.  A Simple, Positive Semi-Definite, Heteroskedasticity and Autocorrelationconsistent Covariance Matrix , 1986 .

[14]  Tarun Ramadorai,et al.  Hedge Funds: Performance, Risk, and Capital Formation , 2006, The Journal of Finance.

[15]  Fischer Black,et al.  How to Use Security Analysis to Improve Portfolio Selection , 1973 .

[16]  Joseph P. Romano,et al.  The stationary bootstrap , 1994 .

[17]  P. Perron,et al.  Estimating and testing linear models with multiple structural changes , 1995 .

[18]  B. Efron.  Bootstrap Methods: Another Look at the Jackknife , 1979 .

[19]  J. Okunev,et al.  Hedge Fund Risk Factors and Value at Risk of Credit Trading Strategies , 2003 .

[20]  R. H. Smith,et al.  Investing in mutual funds when returns are predictable , 2006 .

[21]  Bing Liang.  Hedge Funds: The Living and the Dead , 2000, Journal of Financial and Quantitative Analysis.

[22]  W. Härdle,et al.  Bootstrap Methods for Time Series , 2003 .

[23]  David Hinkley,et al.  Bootstrap Methods: Another Look at the Jackknife , 2008 .

[24]  W. Fung,et al.  The Risk in Hedge Fund Strategies: Theory and Evidence from Trend Followers , 2001 .

[25]  Richard W. McEnally,et al.  The Performance of Hedge Funds: Risk, Return, and Incentives , 1999 .

[26]  Ľuboš Pástor,et al.  Investing in Equity Mutual Funds , 2001 .

[27]  David A. Hsieh,et al.  Hedge Fund Benchmarks: A Risk-Based Approach , 2004 .

[28]  V. Agarwal,et al.  Multi-Period Performance Persistence Analysis of Hedge Funds , 1999, Journal of Financial and Quantitative Analysis.

[29]  W. Fung,et al.  A primer on hedge funds , 1999 .

[30]  M. Kenward,et al.  An Introduction to the Bootstrap , 2007 .

[31]  Richard J. Zeckhauser,et al.  Hot Hands in Mutual Funds: Short‐Run Persistence of Relative Performance, 1974–1988 , 1993 .

[32]  David Hsieh,et al.  Performance Characteristics of Hedge Funds and Commodity Funds: Natural vs. Spurious Biases , 2000, Journal of Financial and Quantitative Analysis.

[33]  M. Verbeek,et al.  Evaluating Mutual Fund Performance and its Persistence using Shrinkage Estimators ∗ , 2003 .

[34]  Russ Wermers,et al.  Can Mutual Fund 'Stars' Really Pick Stocks? New Evidence from a Bootstrap Analysis , 2005 .

[35]  C. S. Jones,et al.  Mutual Fund Performance with Learning Across Funds , 2002 .

[36]  Jessica A. Wachter,et al.  Should Investors Avoid All Actively Managed Mutual Funds? A Study in Bayesian Performance Evaluation , 2001 .

[37]  Ľuboš Pástor,et al.  Credit Suisse Asset Management , 2000 .