Hedge Fund Performance Persistence: A New Approach

Recent literature has found some evidence of performance persistence in hedge funds. This study investigated whether this persistence varies with fund characteristics, such as size and age. Previous research has found that funds face capacity constraints, that investment flows chase past performance, and that as funds age, they become more passively managed, which reduces the likelihood of performance persistence as funds grow older and larger. Consistent with this model, this study found that performance persistence is strongest among small, young funds. A portfolio of these funds with prior good performance outperformed a portfolio of large, mature funds with prior poor performance by 9.6 percent per year. When an investor is selecting a hedge fund for investment, is the fund manager’s prior performance record helpful? If past performance is indicative of future results, this information is valuable. If not, investors may be better off selecting a manager on the basis of the manager’s reputation, investment style, or trading costs. Research on persistence in hedge fund performance has delivered mixed results: Early research found evidence of short-term (one-month to three-month) persistence but no evidence of long-term persistence. Some recent research, however, has found evidence of one-year to three-year performance persistence.A separate strand of the hedge fund literature links fund characteristics—such as size, age, and investment inflows/outflows—to performance, with mixed findings. Recent work has provided a theoretical model that links performance persistence and fund characteristics. The results of this model indicate that, although skilled active managers probably exist, active managers typically do not beat their passive benchmarks and also that performance persistence among managers is unlikely. With this model, investors learn about hedge funds through past fund performance and then rationally supply capital to the best past performers. In general, the model implies that, all else being equal, young and/or small funds should have superior performance.Using data provided by Credit Suisse/Tremont Advisory Shareholder Services for the 1994–2004 period, I investigated performance persistence among hedge funds—both single-strategy funds and funds of hedge funds—by composing quintile portfolios of funds on the basis of past performance. The primary measure of past performance was the 36-month t-statistic of alpha (also known as the “information ratio”). I then investigated whether simple sorts on prior-period fund size and fund age have power to detect performance persistence. Next, I examined whether the predictions of the model hold by performing independent sorts of funds on past IR quintiles and fund characteristic (size and age) terciles.The tests in the study found evidence that strongly supports the model: Portfolios of young, small funds that were past good performers outperformed portfolios of older, larger funds with past poor performance by a statistically significant 9.6 percentage points per year. In contrast, persistence tests in which funds were selected for portfolios on the basis of past performance alone found a difference in performance between past good performers and past poor performers of about 3.9 percentage points annually. Hence, investors can significantly improve their ability to select future good performers by choosing the smaller, younger funds that have shown past good performance.