Evaluating hedge fund managers: A Bayesian investigation of skill and persistence

The last couple of decades has witnessed a growing interest in hedge funds. Academics and practitioners are intrigued by the distinct characteristics of these investment vehicles: hedge funds are flexible with respect to the types of securities they hold and the type of positions they take; they are not subject to public disclosure of their activities; and they are not evaluated against a passive benchmark. Operating in this environment encourages hedge fund managers to construct highly dynamic trading strategies and as a result expose their portfolios to a plethora of economic risk factors. From the investor point of view, very little is known about the investment process, the economic risks associated with a particular hedge fund or a hedge fund strategy, and the skills of the hedge fund manager. While the details of the investment process could be of little practical importance to the investor, the latter – risks and managerial skill - are not. The objective of separating ‘alpha’ and ‘beta’ - the non-systematic and systematic components of returns respectively – is thus one of the main themes of current interest on hedge fund investing. This work introduces a Bayesian approach to estimate the ‘alpha’ and ‘beta’ of hedge fund investments. The Bayesian analysis consists of parameter estimation and model selection, and is implemented via Markov Chain Monte Carlo methodologies. The proposed stochastic search algorithm is appealing in identifying the relevant systematic risk factors in situations where the set of possible factors is very large, i.e. in hedge funds (‘black box’ investments). The entire analysis is carried out in a dynamic setup where hedge fund return volatilities change over time. We address two empirical questions. First we examine if the proposed methodology has an impact on the relative ranking of hedge fund managers compared with current approaches. Second, we study the nature of persistence in hedge fund return performance, i.e. short- or long-term. These questions are extremely interesting for the practice of hedge fund investing. A reliable ‘alpha’ estimation leads to more efficient manager selection schemes, i.e. fund of hedge funds or multi-strategy funds. In addition identifying the nature of persistence in hedge fund investment performance helps in determining successful portfolio rebalancing strategies (timing).