Managers in the $2.9 trillion global hedge fund industry commonly market themselves as consistently delivering “alpha,” a return above a benchmark or market return, while controlling the level of systematic risk, or exposure to a broad range of negative shocks.
A newly published study finds, however, that only a few skilled hedge fund managers are able to effectively manage both systematic risk management (SRM) and asset selection across the economic cycle – and it is these skilled managers who are able to significantly deliver alpha benefits in strong market conditions.
“The skill to select assets that are under and over-valued is different from the skill of maintaining low systematic risk and anticipating market conditions that may disrupt the long-short hedge,” says the study published in the Journal of Banking & Finance, which examines US hedge funds over a 15-year period.
Hedge funds typically have two ways of generating returns: by picking the right assets (stocks and bonds, for example) or by choosing the right asset class to move into (equity or debt, for example). While there has been extensive research into hedge funds’ skill in picking assets, “relatively little attention” has been paid to SRM through choosing the right market to invest in, says the study, entitled “Do hedge funds dynamically manage systematic risk?”
“Many hedge fund managers claim that they earn absolute returns that are unaffected by the risk of the market,” says co-author Raghavendra Rau, Sir Evelyn de Rothschild Professor of Finance at Cambridge Judge. “In fact, this is not easy, as systematic risk commonly goes up during market downturns. But our study shows that it’s possible, at least to some extent, to identify funds that are good at managing systematic risks.”
Specifically, the study finds that by better managing SRM throughout the economic cycle, via active adjustments to investments, skilled hedge fund managers are able to devote less attention to SRM in strong markets and “this re-allocation of attention results in significant alpha benefits” through superior asset selection, says Professor Rau.
The study is co-authored by Ethan Namvar, Lecturer in Finance at the University of California, Berkeley; Dr Blake Phillips, Assistant Professor in Finance at the University of Waterloo, Dr Kuntara Pukthuanthong, Associate Professor in Finance at University of Missouri, and Professor Raghavendra Rau of Cambridge Judge Business School.
The study looks at hedge fund data from 1996 through 2010 based on a sample of 1,324 hedge funds for which low systematic risk is a stated objective. On average, these funds managed $271 million in assets and charged management fees of 1.3 per cent, and had an average life of 57 months.
Among other findings, the research found that SRM skills are related to the education and experience of hedge fund managers, that larger and older funds (which likely attract better qualified managers) typically have higher SRM skill, and that SRM skill is lower for managers who manage funds with low investor flows.