Hedge Fund Performance In Decline? Actually, No.
Conventional wisdom, emphatically reinforced by the media, states that hedge fund performance is in permanent decline. Fill in the blank as to whether it’s attributed to capital flooding the marketplace, fee-greedy managers or the rise of passive management. The list goes on.
One piece of the puzzle that is less well-covered, either because the media lacks access to high-quality data or the tools to analyze it, is the effect of interest rates on overall manager performance. For example, in a low-rate environment, managers pay to short rather than receive a rebate. If we evaluate industry returns over the past 20 years while controlling for interest rates, we can clearly observe a meaningful relationship between interest rates and aggregate hedge fund performance.
Specifically, using the PivotalPath Composite Index, we note that the negative slope effect, essentially the perceived decline in performance, virtually disappears when we correct for returns in excess of the risk-free rate.
Or, for the more statistically minded, fitting a linear regression rt = a + bt + _t on the Index returns, we found a positive and statistically significant intercept a (reflection of positive full sample mean) and a negative slope b, at both the Composite level as well as for individual sub-strategies. The negative slope effect mostly disappears when we consider excess returns.
If excess returns remain relatively constant, it follows that manager’ skills and opportunities should persist. In fact, in a higher interest rate environment, investors should expect a commensurate increase in absolute returns. In either environment, investors should always strive to separate those who generate quality alpha from the rest of the pack - PivotalPath’s predictive rating system empowers institutional allocators to do so.