The way to predict hedge fund returns

Financial theory states that risk and expected return are related, so a new study analyzed hedge funds' exposures to various risk factors to see if those same factors predicted returns.

The study, Do Hedge Funds' Exposures to Risk Factors Predict Their Future Returns?, covered the period 1994 through 2008, using data from the Lipper TASS database, which contains information on 12,980 live and defunct hedge funds with close to $1.8 trillion under management. The following is a brief summary of the study's most important findings.

Market factors

The study looked at five trend-following factors, as well as four other factors:

-- Market (the premium of stocks over one-month Treasury bills)
-- Size (the premium of small-cap stocks over large-cap stocks)
-- Value (the premium of value stocks over growth stocks)
-- Momentum (the premium of stocks with high relative returns over the past year over those with poor relative returns)

The study found that the positive link between exposure to risk and future hedge fund returns was economically and statistically significant -- as was the negative link between inflation and future hedge fund returns.

Risk meant reward

Hedge funds with higher exposure to the risk factors mentioned above in one month saw higher returns in the following month, meaning they were compensated for taking incremental risks. Hedge funds with the highest exposures to these risk factors generated annual returns that were 5.6 percent greater than the funds with the lowest exposures to risk.

Inflation hurt

Hedge funds with lower exposure to inflation in one month generated higher returns in the following month. The average annual returns of the funds with the lowest inflation exposure were 4.7 percent higher than the average annual returns of funds with the highest inflation exposure.

This second finding is partially due to the uncertainty of inflation. As inflation rises and the associated uncertainty increases in the economy, we should see a decline not only in hedge fund returns, but also in the returns of all financial instruments over the following months. Conversely, when inflation is stable and uncertainty is low, we should expect to see positive and attractive returns for all financial instruments, including hedge funds, in the following months.

The authors found that their results were robust across different subsample periods and states of the economy. They also noted that other studies have found that liquidity risk (which is the risk that the investment can't be bought or sold quickly without driving prices against yourself) is an important determinant in hedge fund returns. Hedge funds with significant liquidity risk outperformed those without heavy liquidity risk by an average of 6 percent annually.

This study contributes to the literature demonstrating that hedge fund returns are predominately determined by exposure to common risk factors -- not manager skill. Hedge fund investors are paying more for outperformance, but only getting what the market provides. Therefore, investors seeking higher returns should avoid hedge funds, and gain access to the risk factors they want in lower cost ways, such as index or other low-cost, passively managed funds.