Examining the performance persistence in the funds of hedge funds (FoHFs) industry, the authors find FoHFs that show performance persistence over the short term are more likely to display performance persistence over the longer term. In addition, FoHFs without a hurdle rate have higher performance persistence than FoHFs with a hurdle rate.
Considering that compared with mutual funds, investments in funds of hedge funds (FoHFs) are illiquid in nature, have a long lock-up period, and have infrequent redemption notices, little is known about the performance persistence of FoHF managers. A surprising fact that the authors highlight is that FoHFs from the smallest quartile (in terms of assets under management) exhibit the highest performance persistence. Their analysis also reveals that FoHFs with incentive fees that are less than the average show more performance persistence than those with higher-than-average incentive fees.
How Is This Research Useful to Practitioners?
As of April 2011, FoHFs had more than $1.1 trillion in assets under management. They also seem to be gaining more acceptance by institutional and high-net-worth investors. Compared with the mutual fund industry, which follows traditional benchmarks, FoHFs report absolute returns, making it difficult for investors to judge their financial performance. Numerous studies have been done to measure the performance persistence of the mutual fund industry, but little is known about the performance persistence of FoHF managers. The authors fill this gap by examining the performance persistence of FoHFs for a brief period (1994–2010) that contains bullish as well as bearish markets.
It has been observed that larger FoHFs charge higher incentive fees than smaller FoHFs. But the authors’ findings suggest that FoHFs with incentive fees that are less than the average show more performance persistence than those that have incentive fees that are higher than the average. In addition, they find that such characteristics as a hurdle rate and high-water mark play a vital role in the performance persistence of FoHFs.
How Did the Authors Conduct This Research?
The authors consider data from the Hedge Fund Research database for 4,381 FoHFs for the period of January 1994 to December 2010. The time period of 16 years covers bull market periods (pre-2000 and 2003–2007), bear market periods, and the 2007–09 financial crisis. They have a mix of 1,885 live and 2,496 dead FoHFs reporting monthly net returns. The FoHFs are classified into four categories—conservative, diversified, market defensive, and strategic—based on the strategies used by the funds they hold. The authors exclude all FoHFs with missing classifications and no covariance data. They implement both a cross-product ratio and chi-square statistic to detect persistence.
Much has been written about the performance persistence of mutual funds and hedge funds, but this research article offers a lot of insights into the uncharted territory of FoHFs.