Performance Persistence: Understanding Its Importance
The concept of performance persistence — the idea that past performance can indicate future results — is crucial for investors. If top performers consistently deliver the best returns, investors tend to choose these, even at higher fees. However, when performance persistence is weak, investors need to use additional metrics and skills to evaluate investment opportunities more effectively.
In this blog post, we’ll explore the concept of performance persistence in hedge funds and how investors can adapt their strategies accordingly.
Does Performance Persistence Exist In Hedge Funds?
Evidence suggests that while performance persistence in hedge funds does exist, it’s relatively weak. Only a small fraction of funds consistently outperform, whether considering absolute or risk-adjusted returns. This trend of diminishing returns among top funds has become more pronounced in recent years. Conversely, funds in the bottom decile tend to consistently underperform.
Moreover, performance persistence varies with market conditions and investment strategies. It’s more pronounced in bullish markets and tends to weaken significantly during recessions and bear markets.
In summary, the performance persistence of top decile funds is limited and highly dependent on strategies, time horizons, and market conditions. Nevertheless, consistently poor performers remain at the bottom.
Strategies For Different Scenarios
When performance persistence is strong, investors might focus on gaining access to top-performing funds, considering the potential for high-quality returns justifies the higher fees.
However, in scenarios where performance persistence is weak, investors must refine their selection skills. The importance of accessing specific funds diminishes as today’s top performers might not maintain their status. Investors should avoid underperforming funds and adopt a more comprehensive approach to hedge fund selection. This involves analyzing risk metrics, like skewness, to understand a fund’s future risk profile and the fund manager’s ability to handle downside risks. Factors such as fund size, the fund manager’s expertise in investment and risk management, and their investment philosophy are crucial in fund selection.
Diversification across various hedge fund strategies is also beneficial. Even investors with average skills in selecting fund managers can achieve above-average risk-adjusted returns by minimizing risk through a well-constructed, diversified hedge fund portfolio.
References:
Agarwal, V., & Naik, N. Y. (2000). Multi-Period Performance Persistence Analysis of Hedge Funds. The Journal of Financial and Quantitative Analysis, 35(3), pp. 327-342
Bollen, N., Joenväärä, J., Kauppila, M. (2023). The Decline in Hedge Fund Performance Persistence.
(http://dx.doi.org/10.2139/ssrn.4596230)
Heuson, A.J., Hutchinson, M.C., Kumar, A. (2019). Predicting Hedge Fund Performance When Fund Returns Are Skewed. Financial Management, 49(4).
Jagannathan, R., Malakhov, A., & Novikov, D. (2010). Do Hot Hands Exist Among Hedge
Fund Managers? An Empirical Evaluation. The Journal of Finance, 65(1), pp. 217-255
Kazemi, H. (2021). Performance Persistence: Is It There, and Can It Be Exploited? (https://caia.org/blog/2021/06/03/performance-persistence-is-it-there-and-can-it-be-exploited)
Stafylas,D., Andrikopoulos, A., Tolikas, K. (2023). Hedge fund performance persistence under different business cycles and stock market regimes. The North American Journal of Economics and Finance, 64(C).
