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Hedge Fund Performance Persistence: A New Approach Author(s): Nicole M. Boyson Reviewed work(s): Source: Financial Analysts Journal, Vol. 64, No. 6 (Nov. - Dec., 2008), pp. 27-44 Published by: CFA Institute Stable URL: http://www.jstor.org/stable/40390231 . Accessed: 05/04/2012 00:29
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Financial Journal Analysts 6 Volume64 . Number 2008, CFAInstitute

w^ * w *'/%' I K L* 9

Hedge Fund Performance Persistence: A New Approach

Nicole M. Boyson
in Recent literature foundsomeevidence performance has of persistence hedge funds.Thisstudy whether persistence this varies with characteristics as sizeandage.Previous , such investigated fund that investment research found thatfundsface capacityconstraints, has flows chase past and morepassively whichreducesthe managed, performance, thatas fundsage, theybecome and larger. withthismodel, likelihood performance as fundsgrowolder Consistent of persistence thisstudy that is strongest small, funds.A portfolio found performance persistence among young these withprior a portfolio large, mature of funds goodperformance outperformed of fundswith prior poorperformance 9.6 percent year. by per an investor selecting hedge a is fundforinvestment,thefundmanis record performance helpager'sprior If ful? pastperformanceindicative is of future this is results, informationvaluable.Ifnot, investors be better selecting manager off a on may thebasis ofthemanager's investment reputation, or costs. style, trading in on Research persistence hedgefund performancehas obtained mixedresults. Earlyresearch found of evidence short-term to (one-month threebut no evidenceof long-term month) persistence Recent workby Fung,Hsieh,Naik, persistence.1 and Ramadorai(2008),Jagannathan, Malakhov, and Novikov and Naik,and Teo (2007), Kosowski, found evidence long-term of however, (2007), (oneyeartothree-year) performance persistence.2 A separate strand thehedgefund of literature linksfundcharacteristics, as fundsize, age, such andinvestment inflows to /outflows, performance. As forfundsize, Amene,Curtis, and Martellini a (2003)and Boyson(2007)documented positive between size and performance, relationship whereasHarriand Brorsen a (2004)documented (2005)founda negative relationship. Getmansky betweenfund positiveand concaverelationship size and performance, thatfunds whichsuggests have an optimal size and thatexceeding size this has a negative on performance. impact the of Investigating effect fundage,Agarwal, and Daniel,and Naik (2007), Amene, Curtis, Martellini Goetzmann, (2003),Boyson(2007),Brown,
NicoleM. Boyson an assistant is at professorfinance of Northeastern Boston. University,
November/December2008

and Park(2001),and Liang (1999)documented a betweenage and perfornegativerelationship mance. Kosowski al. (2007)arguedthat best et the ofhedgefunds tendtoholdfunds an of portfolios intermediate age. as flows, Goetzmann, Finally, forinvestment and Ross (2003) showed thattop perIngersoll, formers outflows capital.Agarwal, of experience and Naik (2007),Fung et al. (2008),and Daniel, Kosowski al. (2007)showedthat et with funds high in in inflows thepastexperience performance poor thefollowing and Verbeek (2007) period. Baquero showedthat, investors withdraw although money from past "loser"funds, theydo notsuccessfully funds. contrast, In "winner" exploit past Ding,Getand Wermers showedthat (2007) mansky, Liang, fund flows future predict performance. hedgefund workby Berkand Green(2004)proRecent videsa theoretical between link performance perand fundcharacteristics. resultsof sistence The their modelindicate skilledactive that, although the exist, active managers probably managers typand icallydo notbeat their passivebenchmarks alsothat performance persistence managers among is unlikely. result This occurs because:
investors to competitively supplyfunds manreturns for agers and thereare decreasing in their managers deploying superior ability. and increase size oftheir the funds, Managers their owncompensation, thepoint which at to returns investors competitive to are expected forward. and 2004, 1271) (Berk Green going p.

In the model (henceforth, BG model), the investors learnabout hedge fundsthrough past fund and performance rationally supply capitalto
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Financial Analysts Journal

thebestpast performers. Becausethismodelis a the model, flow-performance relationship learning haverelais more extreme young for which funds, fewreturns investors use to assess that can tively In for funds performance. contrast, moremature with longer returnhistories,each successive in return proportionately important less is period's with funds Hence,young assessing performance. will strong past performance receivesignificant At inflows. some point,thesefundswill capital that fund will the skills be growso large manager's toothin thefund's will trades have and/or spread a larger and higher transaction costs priceimpact thanpreviously bothof whichcompromise the fund's ofthegood Thus,persistence performance. in future unlikely. of is performancesucha fund the I tested implications theBG modelfor the of I theperformance of persistence hedgefunds. first investigatedperformance persistenceamong of quintileportfolios hedge fundsby forming I included funds thebasisofpastperformance. on all hedge funds bothsingle-strategy fundsand of and funds hedgefunds in themainanalysis, I also performed The primary testsby category. measureof past performance the 36-month was f-statisticalpha(alsoknown the"information of as and ratio," IR), whichis widelyused in practice was suggested Kosowskiet al. (2007).I then by whether sorts prior-period on investigated simple fundsize and fundage havepowerto detect performance persistence. whether predictions the of Next,I examined the BG model hold by performing independent of and sorts funds pastIR quintiles fund on characfor teristic terciles that a totalof15 portfolios is, each fund characteristic variable. The model impliesthatsmall fundswill outperform large and will funds young funds outperform funds. old is to of et Myapproach similar that Kosowski in al. (2007). followed Carhart (1997) They, turn, by of on basingportfolios hedgefunds risk-adjusted and whether theseportpastperformance testing in future. imporAn folios exhibited persistence the tant contributionKosowski al. (2007) of et practical is that whenhedgefunds wereselected the on basis ofpastperformance, strongest the was persistence selected usingthei-statistic of among portfolios by than alpha itself.3 alpha (the fund'sIR), rather BecauseusingtheIR arguably the improves precision of the selectionprocess,I also used this the of approach, although mainresults thestudy still heldwhenfunds on wereselected thebasisof Kosowskiet al. (2007) documented alpha itself. in but performance persistence hedgefunds, they did not focusmuchon whether persistence this If varieswithfundcharacteristics.theBG model
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I holds forhedge funds, expected to persistence funds withdifferent differ characteristics.4 among to is My study also related thatofFunget al. of consisted only funds (2008). Usinga samplethat foundthata subsetofthesefunds offunds, they delivered alpha(i.e.,had performance consistently These"havealpha"funds weremuch persistence). less likelyto liquidateand receivedlargerand investment flowsthantheir "beta only" steadier with whichis consistent theprediccounterparts, tionofBerk and Green(2004)that investors ratioAlso nally allocatecapital to good performers. consistent theBGmodelwas that with inflows into funds of thehave-alpha reducedtheability these funds continue to delivering alphain thefuture. thatofFunget al. differs from My approach focused (2008)in an important Whereas way: they on whether inflows successful to funds erode high the performance those funds (a time-series of I approach), used a cross-sectional approachand in addressed whether fund varies the performance cross section discrete for critical valuesoffund age and fund I that size.In a sense, was assuming high flows goodfunds into erodeperformance, which is with andI was attempting consistent their findings, to quantify magnitude thiserosion. the of Hence, both studiestestedthe implications the BG of modelbutin different ways. In general, maindifferences the between my and priorstudiesof theflow-performance study are (or relationship performance persistence) that researchers focusedon the relationship (1) prior and between fund flows future for past performance a given fund portfolio funds (2) they or of and used a time-series of approachto answerthequestion whether pastinflows erode future perforfund high In I analyzed impact critical mance. contrast, the that levelsoffund and flows haveon theperage,size, sistence thecrosssection hedgefunds exisin of of at intime. other In I tence a particular words, point triedto answerthe questionof whether discrete critical valuesinfund (orfund havelasting size age) effects performance isthere optimal on an fund (e.g., I size [age]?).To my knowledge, am the first to address question this with type approach. this of

Data
Data were providedby CreditSuisse/Tremont Shareholder Services (TASS).TASS has Advisory been collecting from hedge fund data directly sincethelate 1980sand has morethan managers and "dead,"in itsdataboth"living" 3,000 funds, base.5The databaseincludesmonthly net-of-fee returns, fees, size,terms, and style expenses, age, ofthefunds.
2008, CFA Institute

Hedge Fund Performance Persistence

and I carried persistence for out tests one-year that over used alphascalculated periods two-year each For theprior months.6 alltime 36 frames, fund in the had tohaveatleast$20million assets during January1994-December2004 period and 24 in months returns a given36-month of period. I an Inconstructing sample, hadtoconsider the hisor issue:the"backfilling" "instant important and On bias tory" (seeEdwards Park1996). thedate it that to TASSadds a newfund itsdatabase, backmana hedgefund returns. fills historical Typically, amountof a ager will start fundwitha limited to shares thepublic; before personal capital selling a record attract to thehopeis tocompile goodtrack in most arrive outsideinvestors. Therefore, funds of thedatabasewitha history strong performance which biases that never available thepublic, to was is This difference oftenlarge: returns upward. Fungand Hsieh (2000) UsingtheTASS database, The the 3.6 calculated biasas about percent year. per in mysampleis about incubation period average the to for bias,I dropped oneyear; thus, control this fund. for actualincubation period every the The finalsample on whichI performed bothlivconsisted 3,333 of tests funds, persistence dead as well as living ing and dead.7 Including in is funds an analysisofperformance important in dead funds a samplecan becausenotincluding dataset bias returns upward.8Using a different
Table 1. Summary Statistics
Year/Style A. Funds year by 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 B. Funds style by selection Security Directional value Relative Multiprocess Fundoffunds

and from oneI used,Brown, the Goetzmann, Ibbotthis son (1999)calculated upwardbias tobe about 3 percent per year.Liang (2000) comparedtwo databases(those HedgeFund of hedgefund major that and Research TASS)andfound theTASSdatabase contained more dead fundsthanthe HFR bias database.He calculatedsurvivorship in the TASS data of about2 percent year,whichis per to comparable mysample. and I for illiquidity Finally,controlled possible in assets usingthe serial correlation hedgefund by of Lo, approach Getmansky, and Makarov(2004), and Liew of which similar that Asness, is to Krail, a includes (2001). priorThey developed modelthat variableand as period returns an independent of returns found statistical significanceprior-period for for tothree oflaggedreturns. Hence, up periods I each hedgefundin mysample, used thecoeffiet three cients by perireported Getmansky al. for All the used in ods to "unsmooth" returns. returns in article unsmoothed.9 are thetests reported this for Table 1 reports statistics thesamsummary data forall ple of hedge funds.Panel A reports fundsforeach yearof thesample.Note thatthe number funds, of averagefundsize,and average in fundage grewsignificantlythesampleperiod. but fund flows werealways positive, over Average variedin size,witha low of40 percent time, they in 1995and a highof126percent 1997. in

Annual Average Number Average of Size Average Age Excess Return Funds (months) (millions) 1,076 1,289 1,520 1,723 1,955 2,125 2,379 2,580 2,460 2,089 838 234 231 248 653 $ 74 83 103 97 116 122 171 180 238 349 $137 155 169 260 109 12% 14 13 1 27 5 3 1 16 6 16% 11 7 10 5 40 42 45 48 50 53 54 56 66 78 52 54 46 59 54

Annual Average Investment Inflow 40% 88 126 56 79 88 91 67 103 48 86% 71 94 83 49

The of is annualexcess return Notes: number uniquefunds theentire for Average sample period 3,333. and and of annual investment inflow is netofall expenses fees is inexcess theU.S.T-bill rate. Average is a percentage prior-period of assets. November/December2008 www.cfapubs.org 29

Financial Analysts Journal

Once formed, werethenheld fora portfolios of either one or two years.This holding period For periodis the"evaluation period." eachevaluaI tionperiod, re-formed on portfolios thebasis of for the precedingformation three-year alphas in period.This processresulted a timeseriesof returns eachquintile for To monthly portfolio. facilitate comparisonwith Fung et al. (2008) and et I in Kosowski al. (2007), performed tests the the andbygroups fund of aggregate styles. groups My are All Funds,All but FOF, and FOF Only.I also broke theAllbutFOF group out into selecsecurity directional relative and multition, trader, value, I performed theanalyses all Furthermore, process. insubperiod for tests January 1998, 1994-September October1998-March 2000,April2000-December and 2003-December 2004.11 2002, January Table2 reports for results portfolios formed on the basisofseven-factor alphas(PanelA) and,then, seven-factor eachoftheportfolios calas alphasfor culated theevaluation for B and C). (Panels periods In theevaluation period,a statistically significant difference between best(Quintile and worst the 5) is of (Quintile portfolios evidence performance 1) inmeans f-tests differences of were used persistence; to calculatethe statistical Because significance. -tests from can ordinary least-squares regressions I calculated -statistics be unreliable, all throughout thearticle using bootstrap the of by approach Politis and Romano with iterations. 1,000 (1994) Tests of Persistence For theformation period(PanelA), thetotal number fundyearsin each quintileis about of I carried testsof persistence out whenI selected with average an number funds yearof of 3,050, fundsby past performance, whenI sortedsepaper about340.Taking overindividual fund size and fund and whenI used funds, averages rately by age, I found quintile the 5 bothfund size (age) and pastperformance. Quinspread(Quintile minus tile1) in 36-month alphasin theformation period to be 2.86percentage Funds Selected by Past Performance. Fol(about40 points month per Carhart and Hendricks, Patel, Zeck(1997), percentage points year)andthequintile per spread lowing in excessreturns be 1.98percentage to hauser (1993), Jagannathan al. (2007), and et points per 27 These Kosowski al. (2007), sorted et I funds intoquintile month (about percentage points year). per on spreadsare largeand implya portfolios thebasis oftheir prior performance. formation-period in Not all funds had availablethefulltimeseriesof good deal ofdispersion returns. but Table2 reports evidence statistically of returns, so long as the fundhad at least 24 signifmonths return ina given of data 36-month I icantpersistence boththe one-year for and twoperiod, it included intheanalysis. sort funds, used I To the yearevaluation periods(see PanelsB and C). For evaluation alphasfrom Fungand Hsieh's(2004)seven-factor the testson All Funds,the one-year modelas calculated overtheprior In three years.10 periodhas a statistically alpha spread significant I funds portfolios thebasis into on 5 addition, sorted (Quintile minusQuintile of37 bps permonth 1) oftheir -statistics theseven-factor for 4.5 will Readers (about percentage alpha,their points year). per IRs.Kosowski al. (2007)reasoned sorting et that in on see persistence neither FOF Onlygroupnor the theIRreduces noise-to-variability andlimthe ratio the security selection For category. the two-year itstop and bottom withalphas to quintiles funds period (Panel C), the spread forthe All Funds thatmaybe moreprecisely calculated thanwhen thanitis fortheone-year groupis higher period, I is and inPanelC, all theindividual alphaitself used.Hence, used theIR whenpercategories except the of for multiprocess the havestatistically forming majority myanalyses, although my category sigresults not were affected whenI usedactual nificant The subperiodresults(not alphas. persistence.
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PanelB ofTable I reports samevariables the fundstyle and aggregated overtime. The five by are thoseused by Kosowski al. et categories style etal. (2007). areas (2007), following Agarwal They follows(expanded definitions specificfund of are A): styles giveninAppendix security whichincludesthe TASS selection, category long-short hedgefunds, directional whichincludesemerging traders, and markets globalmacro hedgefunds, relative value, whichincludesfixed-income arbitrageand convertible arbitrage hedge funds, multiprocess, which includes event-driven and hedgefunds, funds funds. of In terms style, largest of the is grouprepresented it of selection; is followed funds funds. security by werecalculated yearand thenaverAverages by The some aged across years. datain PanelB reflect differences. selectionfunds interesting Security havethe annual 16 returns, percent, highest average whereasfundsof fundshave thelowestaverage annualreturns, percent. 5 fundsare Multiprocess thelargest; funds funds thesmallest. of are Inflows are highest the relative to value funds, whereas funds funds of havethe lowest The inflows. average much fund age doesnotvary by category.

Hedge Fund Performance Persistence

Table 2.

Persistence Tests of Portfolios Formed on Past Performance: Sorting on 36-Month Seven-Factor Alphas, 1994-2004 in (f-statistics parentheses)
AUFunds Alpha 1 Quintile Alpha 2 Quintile Alpha 3 Quintile Alpha 4 Quintile Alpha 5 Quintile 5Quintile 1 Quintile AllbutFOR FOFOnly: 5- Quintile 5Quintile 1 1 Quintile Quintile

Measure

A. Annual period formation of Totalnumber fund 3,052 3,059 3,055 years number Average 339 340 339 offunds/year 36-month Monthly -1.01% -0.04% 0.32% alpha (-1.29) (-0.52) (1.55) R2 35.8 34.5 30.5 Adjusted 0.24% 0.48% excess return -0.35% Monthly statistics B. One-year evaluation period: Portfolio 7-factor Monthly 0.10% 0.17%* portfolio alpha (0.65) (1.72) 53.2 56.4 Adjusted!?2

3,059 340 0.70%*" (2.42) 28.9 0.72%

3,053 339 1.85%"* (2.62) 29.6 1.63%

na na 2.86% na na 1.98%

na na 3.12% na na 2.08%

na na 1.77% na na 1.37%

0.26%*** 0.30%*** 0.47%*** 0.37%** (3.43) 63.2 (4.10) 70.4 (3.09) 62.2 (2.29) na

0.33%** (2.09) na

0.29% (1.34) na

l 5 Breakout AllbutFOF group: of Quintile - Quintile Relative Security Selection Directional Value Multiprocess 7-factor Monthly alpha portfolio 0.18% (1.00) 0.62%*** 0.74%*** (2.44) (4.56) 0.33%*** (2.94) AUFtmds Alpha Alpha 2 Quintilel Quintile 7-factor Monthly portfolio alpha R2 Adjusted 0.12% (0.68) 57.2 0.15% (1.45) 3.7 Alpha 3 Quintile 0.20%*** (2.33) 63.4 Alpha 4 Quintile Alpha 5 Quintile 5Quintile 1 Quintile 0.62%*** (2.47) na

C. Two-year evaluation statistics period: Portfolio AllbutFOF: FOFOnly: 5- Quintile 5Quintile 1 1 Quintile Quintile 0.36%** (2.04) na 0.46%*** (2.80) na

0.30%*** 0.50%*** (4.23) 68.3 (3.67) 56.5

l of 5 Breakout AllbutFOF group: Quintile - Quintile Relative Security Selection Directional Value Multiprocess 7-factor Monthly portfolio alpha 0.30%* (1.87) 0.67%*** 0.57%*** (2.57) (4.69) 0.04% (0.53)

Notes: weresorted quintile into on All a variables: 36-month Hedgefunds portfolios thebasisoftwoseparate alphasarefrom sevenfactor model(Fungand Hsieh2004).Theseven-factor modelwas usedtoassessout-of-sample The portfolio performance. portfolios whena fund wereequally so werereadjusted Portfolios rebalanced theendof were at weighted monthly, theweights disappeared. theone-year two-year or The-statistics calculated usingthebootstrap were with1,000 iterations. For holding period. by approach are statistics reported thetwo-year for brevity, evaluation-period only portfolio holding period. of na FOF = fund funds; = notapplicable. at level. *Statistically significantthe10percent at level. **Statistically significantthe5 percent at level. ***Statistically significantthe1 percent

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Financial Analysts Journal

indicate that persistence this for finding reported) and two-year held the one-year holdingperiods the for 2000 throughout sample period except April toDecember 2002. in Theresults Table 3 arefor based portfolios on theIR (the-statistic theseven-factor of alpha). in and Theseresult similar magnitude signifare
Table 3.

icance to the resultsin Table 2. One important is the nowdemonexception that FOF Onlygroup in strates statistically persistence both significant and thetwo-year theone-year (PanelB) (PanelC) of periods perhapsa result theimproved precisiongainedfrom Also, usingthealpha-statistics. in contrast theresults Table 2, thesecurity in to

Persistence Tests of PortfoliosFormed on Past Performance:Sorting on f-Statistic the of 36-MonthSeven-Factor Model, 1994-2004 in (f-statistics parentheses)
A11Funds -Statistic -Statistic -Statistic -Statistic -Statistic Quintile5Quintile 1 Quintile2 Quintile3 Quintile4 Quintile5 Quintile 1 AU but FOF: Quintile5Quintile1 FOF Only: Quintile5Quintile 1

Measure

A. One-year formation period Total numberoffund 3,052 years Average numberof 339 funds/year 36-month Monthly -0.91% alpha Adjusted R2 Monthlyexcess return (1.31) 33.5 -0.45%

3,059 340 0.02% (0.28) 29.7 0.20%

3,055 339 0.62% (0.91) 29.3 0.63%

3,059 340 1.08%* (1.91) 27.8 0.94%

3,053 339 1.14%*** (4.36) 23.1 1.05%

na na 2.06% na na 1.50%

na na 2.25% na na 1.57%

na na 1.47% na na 1.15%

B. One-year evaluation statistics period: Portfolio Monthly7-factor 0.13% 0.15% portfolio alpha (0.87) (1.36) 60.9 60.9 Adjusted R2 Security Selection Directional Monthly7-factor portfolio alpha 0.21% (1.08) 0.34% (1.44)

0.24%** (2.20) 64.5

0.33%*** (2.93) 64.0

0.45%*** (6.13) 53.6

0.32%*** (2.34) na

0.32%** (2.01) na

0.37%** (2.30) na

Breakoutof All but FOF group: Quintile5 - Quintile l Relative Value Multiprocess 0.61%*** (4.89) 0.34%*** (2.77) All but FOF: Quintile5Quintile1 0.28%** (1.94) na FOF Only: Quintile5Quintile 1 0.42% (3.17) na

C. Two-year evaluation statistics period: Portfolio -Statistic -Statistic -Statistic -Statistic -Statistic Quintile5Quintilel Quintile2 Quintile3 Quintile4 Quintile5 Quintile 1 Monthly7-factor portfolio alpha Adjusted R2 0.09% (0.56) 65.4 0.15% (1.17) 63.5 0.22%* (1.84) 62.0 0.38%*** (3.97) 60.3 0.42%*** (6.44) 59.3 0.33%*** (2.72) na

BreakoutofAll but FOF group: Quintile5 - Quintile l Security Selection Directional Monthly7-factor portfolio alpha 0.25% (1.50) 0.54%*** (2.47) Relative Value Multiprocess 0.46%*** (3.99) 0.23% "

(1.59)

Notes:The -statistics alphas are froma seven-factor of model. See also thenotes to Table 2. na = not applicable. at *Statistically significant the 10 percentlevel. at **Statistically significant the5 percentlevel. at ***Statistically significant the 1 percentlevel.

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Hedge Fund Performance Persistence

in invested thesameopporwhere much too capital tunitiescan drive away profits. Furthermore, in investment opportunities thehedgefundspace and over are often cyclical fallin and outoffavor theoptimal as managers time. Therefore, approach a size for givenstrategy, mustmakea critical they and incentive to stick their decision: knitting collect or optimizethe feesthrough good performance value of themanagement company by enterprise The current out styles. branching to new trading has is on literature silent whichway theindustry that often indicates managers Someevidence gone: niche fundsto new close theirverysuccessful that indicates manbutother evidence investment, advanto funds take multistrategy agers openlarge investment ofchanging opportunities. tage addressthis did Priorliterature not directly on Size and Age. The theon issue.Fungetal. (2008)focused well-diversified Separate Sorting fund a BG oretical modellinks of so age,size,and invest- funds funds, in their analyses, fund's optiTheauthors flows performance to Kosowski ment malsize was an industrywide persistence. question. allocatecapitalto to et al. (2007)formed rationally arguedthatinvestors according broad portfolios the that increases sizeof funds perform which made theimplicit which well, assumpstyle categories, thesefunds.Managersface capacity was broad that constraints, tion their categorization sufficiently ininvesting newcapital. too this size and age. toavoidtheissueoffund however, Notably, muchcapitalin a fundcan spreadthemanager's Incontrast, main focus the is impact fund of my and costsmore skills thin maketrading too An size (and age) on performance expenpersistence. and theprosivein terms bothbid-askspreads of ofthese tests that is arecrossthey aspect important to for at re-formed regular Hence,the sectional,with portfolios pensity largetrades moveprices. a flows result from manager's investment that ifa fund intervals. attracted Thus, very capisignificant will cause thatpertalflows grewlargerelative itspeersin one and to good performance eventually in to to formance diminish thepointthat, equilibfundmovedto a different tercile that size period, a fund'sexpected to are returns investors in thenextperiodand was replaced a smaller rium, by in with of funds thefuture. fund.These testswere designeddeliberately to competitive those other maximizethe probability finding of The BG modelprovides testable persistence implications. based on thepredictions theBG model. of to size.IftheBG Thefirst relates fund implication should modelholds, then I first size examined ability fund andfund the of performance persistence of size as a function fund becauseas funds decrease to performance persistence. age,separately, predict investment that fund the opportunities Notethat BG modeldoes notimply grow,theyhave fewer and higher transaction costs.The secondimplicasize or fundage alone shouldbe able to capture and Green(2004) tionrelates fund to Berkand Green Rather, age. As Berk performance persistence. that investheir modelincludes attract noted, (2004)arguedthatgood funds learning; is, highinvestlearn aboutfunds thefunds and allocate as tors and that mentflows, whichmakesthemlarger, age with to funds assets young attract investment flows goodpastperformance. young good funds higher data funds havefewer Becauseyoung than goodfunds, also them old which makes performance larger. that also Theauthors noted as funds anincreaspoints, capitalflowsto thesefundswill be more age, sensitivethan will flows to older tendsto be of performance inglylargeportion the portfolios as fundsage, theyare more funds. should reduce likelithe which Additionally, managed passively, a to of of portion their portfolios hoodoffinding likely allocate larger persistence goodperformance. to passive strategies. I did notexpectsimplesortson age to have Hence,performance persisalsodecrease a function fund as of tence should between age. powerbecausetherelationship predictive than relationthe is ageandperformancelessdirect Although the BG model was writtento I nevertheless fund of size the the describe mutual shipbetween and performance. industry, question initial the these tests describe unconto fund size (age) is parwhether there an optimal is performed A ditional "baseline" effects size and age. Laterin of relevant thehedge fundindustry. to ticularly in I tests the of strat- thearticle,willreport results direct number hedgefund of of styles operate niche these theimplications theBGmodel. perform of To funds) arbitrage egies (forexample,convertible selectioncategorynever demonstrates perforThe subperiodresults(not mance persistence. indicatethatthis persistence finding reported) in for existed all subperiods theone-year holding it but holding period, did period, in thetwo-year the not existfor. two middle subperiods from March2000 October 1998toMarch2000and from are conto December 2002.Theseresults broadly withthoseofKosowski al. (2007), et sistent Jaganet nathan al. (2007),and Fungetal. (2008). of priorfindings perforHaving confirmed I mance among hedgefunds, nowturn persistence Do of to themainresearch question thestudy: the of predictions theBGmodelapplytohedgefunds? Ifthey this information be ofvaluetoinvescan do, in tors selecting hedgefunds.
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I baseline funds intotercile tests, sorted portfolios on thebasisofprior-period (age) and heldthe size for portfolios one ortwoyears. Table 4 presentsthe resultsof the test to fundsize is relatedto perfordiscoverwhether mance persistence.For the formation period, PanelA showsa largerangein fund size between 1 of Terciles and3 (a difference about$620million) in but does not reveal a significant difference returns. monthly there a is Fortheevaluation however, period, in difference the sevenstatistically significant 1 boththe factor Terciles and 3 for alphasbetween (PanelC) holding (PanelB) and two-year one-year for on Large periods thetests theAHFundsgroup. funds underperformedsmall funds in the 1994-2004 (about1.6 periodby 12 bps permonth
Table 4.

for holdpoints annually) theone-year percentage and by 29 bps per month(about 3.5 ing period for holdpoints annually) thetwo-year percentage Theseresults werelargely driven by ing period. funds.For the one-year holding single-strategy period (Panel B), in the All but FOF group,the small funds(Tercile1) outperformed large the funds but the (Tercile by 17 bps permonth, for 3) outsubsetofFOF Only,thelargefundsactually thesmallones. performed withthe idea are These findings consistent thatbecause fundsof fundsare diversified, the thanit is for be FOF size might higher optimal is funds.This conjecture further single-strategy from thefact Table 1,theaverthat, supported by is which age size ofa fundoffunds $109million, is thesmallest all thesubsets. of

Performance of Portfoliosof Funds Formed on Fund Size, 1994-2004 in (f-statistics parentheses)

AUFunds 1 Tercile $32.4 0.76% 2 Tercile $81.0 0.79% Tercile 3 $652.6 0.87% Tercile 3 1 Tercile $620.2 0.11% (0.55) -0.12%*** (-3.19) na AUbutFOF: 3 Tercile 1 Tercile $663.1 0.06% (1.02) -0.17%*** (-3.84) na FOF Only: Tercile 3 1 Tercile $493.6 0.18% (0.95) 0.08%* (1.74) na

Measure
A Formation Individual period: fundstatistics

Meansize (millions) excess return Monthly

7-factor Monthly portfolio alpha R2 Adjusted

B. One-year evaluation statistics period: Portfolio

0.32%*** 0.21%** (2.70) (2.01) 52.2 51.2

0.20% (1.60) 47.9

1 Breakout AllbutFOF group: of Tercile - Tercile 3 Security Selection 7-factor Monthly portfolio alpha -0.12% (-1.60) Directional -0.09% (-0.77) Relative Value Multiprocess -0.04% 0.00% (-0.62) (0.08) AllbutFOF: Tercile 3 1 Tercile -0.33%*** (-5.30) na FOF Only: Tercile 3 1 Tercile -0.11%* (-1.91) na

G Two-year evaluation statistics period: Portfolio

1 Tercile 7-factor Monthly alpha portfolio R2 Adjusted

2 Tercile

Tercile 3

Tercile 3 1 Tercile

0.57%*** 0.36%*** (5.63) (3.75) 57.6 57.6 Security Selection

0.25%*** -0.29%*** (2.94) (-5.44) 60.5 na Relative Value Multiprocess -0.04% -0.08%* (-0.62) (-1.65)

of Breakout AllbutFOF group: Tercile - Tercile 3 1 Directional

-0.44%*** -0.28%** (-5.63) (-2.14) Note: seven-factor The modelwas usedtoassessout-of-sample performance, na = notapplicable. at level. *Statistically significantthe10percent at level. **Statistically significantthe5 percent at level. ***Statistically significantthe1 percent

7-factor Monthly portfolio alpha

34

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Hedge Fund Performance Persistence

Forthetwo-year holding period(PanelC) for fundsof funds, the between however, difference in thedifferencetheperterciles reverses, although formance theFOF Onlytercile smalland staof is (11 tistically insignificant bps permonth). In general, single-strategy are the results cona with sistent whodocumented (2005), Getmansky concave relationship betweensize and perforthat becometoo large, mance, indicating iffunds The are their can suffer. results also performance With with consistent theBGmodel. broadly respect to the (unreported) the subperiodanalysis, size withthefull-period results. results consistent are that on Table4 indicates sorts size alonefind performance persistence. Table 5 reports resultsforthe relationship betweenfundage and performance persistence.
Table 5.

Similar theresults fundsize,based on the to for between Tercile and Tercile thetests 3 1, spreads in theformation showno significant relationship In for to size,there period. contrast theresults fund are also no statistically relationships significant in between pastage and performance theevaluaresults tionperiods.The (unreported) subperiod of indicated someevidence persistence, however, on for when sorting fundage. Notably, the two 1998-March and 2000 middle (October subperiods thetests found statisMarch 2000-December 2002), thatyoungfundsoutevidence tically significant performedold funds. Thus, the evidence of is persistence mixed when sorting performance on pastfund age. only indicate strong a these results Takentogether, fundsize and between unconditional relationship

Performanceof Portfoliosof Funds Formed on Fund Age, 1994-2004 in (-statistics parentheses)

AH Funds Tercile3 Tercile1 91.4 -0.22% (-0.96) AU but FQF: Tercile3 Tercile1 89.7 -0.26% (-1.09) 0.01% (0.33) na FQF (My: Tercile3 Tercile1 98.0 0.08% (0.45) 0.06% (0.92) na

Measure A. Formation Individual period: fundstatistics Mean age (months) Monthlyexcess return

Tercile1 21.4 0.98%

Tercile2 51.7 0.72%

Tercile3 112.8 0.76%

B. One-year evaluation statistics period: Portfolio actorportfolio 0.25%* Monthly7-f alpha (1.94) 40.0 Adjusted R2 BreakoutofAll but FOF group: Tercile3 - Tercile1 Security Selection actorportfolio Monthly7-f alpha 0.02% (0.24) statistics C. Two-year evaluation period: Portfolio

0.20%* (1.88) 53.9

0.28%*** (2.41) 55.7

0.03% (0.77) na

Directional -0.27% (-1.55)

Relative Value -0.12%* (-1.83)

Multiprocess 0.02% (0.35) AU but FOF: Tercile3 Tercile1 -0.04% (-1.12) na FOF Only: Tercile3 Tercile1 0.01% (0.09) na

Tercile1 Monthly7-factor portfolio alpha Adjusted R2 0.39%*** (3.84) 45.9

Tercile2 0.43%*** (4.51) 61.0

Tercile3 0.36%*** (3.67) 65.5

Tercile3 Tercile1 -0.03% (-0.93) na

BreakoutofAll but FOF group: Tercile3 - Tercile1 Security Selection Monthly7-factor portfolio alpha -0.22%*** (-2.47) Directional -0.13% (-0.70) Relative Value -0.17%*** (-2.98) Multiprocess -0.02% (0.44)

Note:The seven-factor model was used to assess out-of-sample performance, na = not applicable. at *Statistically significant the 10 percentlevel. at ***Statistically significant the 1 percentlevel.

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Financial Analysts Journal

I arbitrarily reduced lastNAVfor liquidated the the levels basispoints: 200, of funds varying 100, 500, by and 2,500. The results themaintests of remained these so I amcomfortable variations, unchanged by of that findings notdriven overreporting are the by smalloryoung funds. lastNAVsfor data eachofthe15portfoTable 6 presents for within of lios and thecalculations thedifferences three each size tercile IR quintile (thebottom by of eachIR rowsinboldface eachpanel)and within Sortingby FundSize (or Age) and Past Performance. To perform testsof the BG columns of my (thelast three quintile size tercile by into model,I sortedfundsindependently quintile on For eachpanelin boldface). example, focusing on for the bestIRquintile theone-year (using portfolios thebasis ofpastperformance holding period, and tercile seven-factor f-statistics) into from the the returns each of the size terciles to portalpha A folioson thebasis offundsize (or age).12 time 52 smallest thelargest respectively, bps,42 to are, for returns the15 portseriesofequallyweighted of bps,and 38bps.Thedifference 14bps is statisticreated theintersection these at of folios was then at the 5 percentlevel, which cally significant The were one sorts. portfolios heldfor ortwoyears, that also topperformare that smallfunds implies and seven-factor that alphas forthe entireholding ersoutperform funds aretopperformers; large for wereusedtotest persistence. predicMy in other period size matters, amongthevery even words, tionsbased on the BG model were thatsmall bestperforming funds. (young)fundsthatwere past good performers Table6 showsthe the rows, Following boldface would significantly outperform large(old) funds in betweenthe portfolio difference performance that werepastpoorperformers. the containing smallest plus bestpastperforming thisportfolio-formation folNotethat process and the funds theportfolio plus containing largest Each fund stayed in its lows prior literature. worstpast performers fundgroupand style by untilthe end of the holding assignedportfolio If is and statisticategory. thisdifference positive If fund to end exited sample the period. tike prior the for the callysignificant, tests providesupport the oftheholding the was period, portfolio rebalanced BG modelprediction beyond optimal that an fund fund the released that to by byreallocating capital that face constraints erode their size,funds capacity that which assumes thefunds remained, implicitly in Theresults PanelA ofTable6 for performance. that at last funds couldbe liquidated their netasset theone-year holdingperiodindicate strong supthat dataareselfvalues(NAVs).Given hedgefund fortheBG model:FortheAll Fundssample, port this could be faulty, reported, assumption espethestatistically difference about8.1 is significant whichmayhave ciallyforyoungor smallfunds, a year(65bps permonth). Note percentage points more failure rates and/or suddenly higher mayfail thattheseresultswere obtainedwithgenerally If than orlarge old is funds. theassumption wrong, diversified without to stratportfolios regard fund on of relying it will bias the returns the small canbe interpreted sugas The which couldexaggerate egyorstyle. results portfolios upward, (young) an fund that has size optimal gesting industrywide the results. severalteststo Hence, I performed but notyetbeenreached somefunds has been by I examine extent this the of bias.First,compared the exceeded others. by the with reathe reasons exiting TASSdatabase for Inthe in one-year for results other sons forexiting anotherdatabase (the CASAM portfolios the thegroup single-strategy of Databasefrom Centhe CISDM HedgeFund/CTA period, portfoholding with lios(AllbutFOF) has an evenstronger result, and ter International for Securities Derivatives Maran excessreturn 8.9percentage of a year(71 that are so points consistent, kets)and found they largely In the for FOFOnly I wasnot funds ailed"when bpsa month). contrast, result the misclassifying as "f they is onlyabout4.2percentage annually group points were, in fact,still extant.Second, I examined whether ratesvariedby size and age in the exit (andsignificant atthe10percent level). only The results singlestrategies the onefor for sampleperiodand foundthatsmallfundswere the selection more to the becauseof"liquidaperiodare that security yearholding likely exit database and directional and havestrong signifition" than werelarge so NAVs funds, overreported categories cantdifferences between of for these funds couldhave affected results. To portfolios smallplus my fundsand large plus low thatthiswas not the case, I perhigh alpha -statistic gain assurance two additional I -statistic that formed tests. First, reranall my funds, alpha f implying theoptimal without liquidated the and fund for size these has funds, second, analyses strategies beenexceeded by (smallfunds outperform performance persistence for and onlyweak evidence, certain largeones) of an unconditionalrelationship subperiods, fund and performance between persistence. age in Withthesebaselinerelationships hand,I testsdesignedto directly the BG test performed I on model;in thesetests, formed portfolios the and size (and age). basisofpastperformance fund
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Hedge Fund Performance Persistence

Table 6.

Performanceof PortfoliosFormed on Independent Sorts on Fund Size and f-Statisticsof 36-MonthSeven-Factor Alphas, 1994-2004 in (f-statistics parentheses)
AU Funds Alpha f-Stat Quintile 1 0.16% (0.75) 0.19 (1.07) -0.11 (-0.54) -0.27*** (-2.38) -0.45*** (-3.16) -0.04 (-0.16) Alpha f-Stat Quintile2 0.08% (0.55) 0.19 (1.49) 0.28* (1.76) 0.19* (1.65) 0.32** (2.12) -0.06 (-0.53) Alpha f-Stat Quintile3 0.31%*** (2.88) 0.17 (1.18) 0.17 (1.16) -0.14 (-1.46) -0.20 (-1.57) -0.30*** (-2.69) Alpha f-Stat Quintile4 0.39%*** (2.97) 0.18 (1.40) 0.26* (1.81) -0.14 (-1.43) -0.14 (-1.15) 0.34*** (2.64) Alpha f-Stat Quintile5 0.52%*** (6.21) 0.42*** (5.30) 0.38*** (5.03) -0.14** (-2.23) -0.14* (-1.73) 0.02 (0.28) Quintile 1Quintile5 Spread 0.36%* (1.72) 0.23 (1.31) 0.49*** (3.19) na na na AllbutFOF: FOFOnly: f-Stat f-Stat Spread Spread 0.26% (1.04) 0.32* (1.65) 0.57*** (3.16) na na na FOFOnly 0.34%* (1.80) Relative Value 0.64% (1.57) Multiprocess -0.09% (-0.34) 0.30% (1.15) 0.71*** (4.76) 0.36** (2.05) na na na

Grouping A. One-year period holding SizeTercilel SizeTercile2 SizeTercile3 All Funds size spread AllbutFOF size spread FOF Only size spread

Difference small fundswithpast high alpha f-statistics for minus big fundswithpast low alpha -statistics Fund groups All Funds AllbutFOF 0.65%*** (3.65) Stylecategories(ex FOF) Security Selection 0.67%*** (2.23) B. Two-year holding period Quintile 1Alpha Alpha Alpha Alpha Alpha f-Stat f-Stat f-Stat f-Stat f-Stat Quintile5 Quintile 1 Quintile2 Quintile3 Quintile4 Quintile5 Spread 0.62%*** 0.54%*** 0.70%*** 0.66%*** 0.66%*** 0.04% (0.27) (3.08) (2.38) (4.83) (7.13) (4.71) 0.14 0.36* 0.33** 0.48*** 0.51*** 0.50*** (0.84) (1.94) (2.88) (2.09) (4.55) (7.17) 0.01 0.27* 0.46*** 0.32*** 0.39*** 0.38*** (2.49) (0.07) (1.69) (4.14) (2.58) (4.62) -0.27*** -0.61*** -0.27* -0.24*** -0.34*** na (-5.44) (-1.88) (-2.41) (-3.28) (-3.31) -0.85*** -0.30* -0.27** -0.37*** -0.36*** na (-5.47) (-1.81) (-2.50) (-2.04) (-4.11) -0.25 -0.39*** -0.06 -0.13 0.08 na (-0.96) (-2.44) (-0.39) (-1.42) (0.78) All Funds AllbutFOF 0.65%*** (3.94) Stylecategories(ex FOF) Security Selection 0.96%*** (3.96) 0.79%*** (3.89) Directional 1.68%*** (4.74) AllbutFOF: FOFOnly: f-Stat f-Stat Spread Spread -0.06% -0.02% (-0.29) (-0.07) 0.09 0.85*** (0.52) (3.35) 0.43** 0.31*** (2.25) (2.58) na na na FOFOnly 0.23%* (1.74) Relative Value 0.90%* (1.70) Multiprocess -0.59%** (-2.15) na na na 0.71%*** (3.27) Directional 1.04%*** (2.48)

SizeTercilel SizeTercile2 SizeTercile3 All Funds size spread All but FOF size spread FOF Only size spread

Difference small fundswithpast high alpha f-statistics for minusbig fundswithpast low alpha f-statistics Fund groups

Notes:Intercepts from each oftheregressions reported. are Size was measured in millionsofdollars.The seven-factor model was used to assess out-of-sample performance. na = not applicable. at *Statistically significant the 10 percentlevel. at significant the5 percentlevel. **Statistically at ***Statistically significant the 1 percentlevel.

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Financial Analysts Journal

for valueandmulsomefunds. results relative The arenotstatistically however, significant, tiprocess of both these displayed perforalthough categories was on past whenthesorting mancepersistence alone(see Table2). performance are Theresults thetwo-year for holding period for one-year similar those discussed the to just quite differences were holdingperiod: The strongest and found theAllFundsgroups theAllbutFOF for of subthe Finally, results the(unreported) group. with of areconsistent those thefullperiod analysis periodanalysis. for formed Table 7 reports results portfolios by sortson age and past performance. independent will that TheBGmodelimplies young, goodfunds because the older fundsprimarily outperform In full funds havenotyetreached capacity. young the themodelpredicts as funds that addition, age, willinvest larger a of assetsin funds portion their whichwould reducethelikelipassivestrategies, old hoodofperformance persistence among funds. I thus calculated the performance difference and between young pluspastgood funds old plus and found bad funds as Table7 reports, that, past fortheAll Fundsgroupin theone-year holding was period(Panel A), thisdifference 44 bps per about 5.4 percentage month, pointsannualized, and highly statistically significant. Table7 proFortheone-year period, holding vides evidencethatyoungfundswithpast good with old pastgood performance outperform funds 10 bps permonth (about1.2perperformance by is Thisfinding consistent centage points year). per withtheBG model, whichpredicts old funds that withpast good performance have receivedthe investment flowsin thepast,whichdamlarger In in ages their performance thefuture. the(unretheage results were ported)subperiod analyses, withthoseforthe fullperiodforthe consistent horizonbut were weakerforthe twoone-year yearhorizon;theywere significant onlyforthe final 2003-December 2004. subperiod, January Theresults so in section indipresented far this with bothsize catethat, consistent theBG model, in and age arerelevant predicting hedgefund performance As persistence. fundsreach capacity, as their deteriorates. performance Similarly, good, their youngfundsreceivelarge capitalinflows, deteriorates. performance Becausetheage and size of fundsare highly and because both (past good) young correlated and (pastgood) smallfunds funds exhibit perforthe test mancepersistence, next was performed on sortson size, age, and past perforindependent manceoffundsto determine whether even more couldbe detected. persistence
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In thefirst of tests, sorted I funds size on set and age to establishthe baseline relationship on between and age byindependently size sorting Nine portfolios wereformed thesetwovariables. In of sorts. Panel the tercile from intersectionsthese A and PanelB ofTable 8, thedifferences between thanthe are thesize terciles columns) larger (the betweenthe age terciles differences (the rows). than factor age size Thus, maybe a more important in detecting Still,age does provide persistence. from tests some explanatory power,and results of smallfunds theperformance young, comparing with that old,largefunds statistically are of signiffor icant theAllFundsand theAllbutFOF groups. of As withthesize results, aggregate the portfolio has the funds, All butFOF group, single-strategy was results: thestrongest Outperformance 18 bps month (about2.1 percentage annually) points per forthe one-year holdingperiodand 28 bps per month (about3.4 percentage pointsper year)for to thetwo-year holdingperiod.Also similar the the the sorts size,for FOF Onlyportfolio, differon encesbetween young plussmalland old pluslarge the aresmalland statistically Finally, insignificant. (unreported) subperiodresultswere consistent with results. these full-period Theseresults perhaps provideevidencethat, because of their diversified connature, capacity than are of straints lessimportant funds funds for for hedgefunds. single-style I In thesecondsetoftests, sorted fundsinto basedonsize,age,andpastperformance. portfolios documentedin Given the strongrelationships to that Tables6 and8,1was notsurprised find these tests havethemost ofall:Panel explanatory power A in Table 9 showsthatfortheone-year holding was young the of period, portfolio All Fundsthat and smalland had goodpastperformance outperformed portfolio was old and largewith the that statistically poorpastperformance a highly by sig77 9.6 nificant bps permonth an impressive percentage points year.Forthetwo-year per holding is 68 theoutperformance bpspermonth (8.5 period, percentage points year). per As forthesize-only the are results, findings thatexcluded moresignificant the portfolio for fundsof fundsthanfortheFOF Onlyportfolio. FortheAll butFOF group(PanelB),theone-year difference 10.5 percentage is points (two-year) whereas the for (11.0percentage points) annually, of portfolio the FOF Only group (Panel C), the is difference 2.2 percentage (two-year) one-year and is stapoints(0.8 percentage point)annually insignificant.13 tistically
2008, CFA Institute

Hedge Fund Performance Persistence

Table 7.

Performanceof Portfolios Formed on Independent Sorts on Fund Age and f-Statisticsof 36-MonthSeven-Factor Alphas, 1994-2004 in (f-statistics parentheses)
All Funds Alpha f-Stat Quintile 1 0.33% (1.40) 0.04 (0.22) 0.07 (0.37) -0.25* (-1.92) -0.58*** (-3.07) -0.29 (-0.65) Alpha f-Stat Quintile2 0.26%* (1.75) 0.17 (1.38) 0.13 (0.87) -0.13 (-1.22) 0.14 (0.96) -0.22 (-1.61) Alpha f-Stat Quintile3 0.12% (0.56) 0.27** (2.12) 0.24 (1.86) 0.13 (1.15) -0.02 (-0.07) 0.05 (0.40) Alpha f-Stat Quintile4 0.53%*** (3.08) 0.16 (1.46) 0.26* (1.89) -0.27*** (-2.25) -0.20* (-1.93) -0.09 (-1.40) Alpha f-Stat Quintile5 0.51%*** (5.65) 0.42*** (5.23) 0.41*** (6.26) -0.10* (-1.66) -0.12* (-1.85) -0.08 (-1.32) Quintile 1Quintile5 Spread 0.19% (0.78) 0.37*** (2.32) 0.34* (1.81) na na na AllbutFOF: FOFOnly: f-Stat f-Stat Spread Spread -0.06% (-0.23) 0.38** (2.08) 0.40** (1.96) na na na 0.42% (1.33) 0.22 (0.93) 0.62*** (2.68) na na na

Grouping A. One-year period holding AgeTercilel AgeTercile2 AgeTercile3 All Funds age spread AllbutFOF age spread FOF Only age spread

for minus old fundswithpast low alpha f-statistics Difference young fundswithpast high alpha f-statistics Fund groups All Funds AllbutFOF FOFOnly 0.44%*** (2.47) Stylecategories Security Selection 0.37% (1.42) B. Two-year period holding Alpha f-Stat Quintile 1 0.34% (1.40) 0.46** (2.29) 0.25 (1.43) -0.09 (-0.62) -0.34 (-1.34) 0.24 (1.03) Alpha f-Stat Quintile2 0.28% (1.61) 0.48*** (3.00) 0.34* (1.89) 0.06 (0.55) 0.00 (0.01) -.11 (-0.60) Alpha f-Stat Quintile3 0.46%** (2.13) 0.62*** (4.40) 0.46*** (3.91) 0.01 (0.12) 0.33 (1.10) -0.33*** (-2.50) 0.52%*** (2.58) Directional 1.46%*** (3.53) 0.70%*** (3.48) Relative Value 1.67%*** (6.20)

Multiprocess -0.03% (-0.14)

AgeTercilel AgeTercile2 AgeTercile3 All Funds age spread All but FOF age spread FOF Only age spread

Quintile 1 Alpha Alpha f-Stat f-Stat Quintile5 Quintile4 Quintile5 Spread 0.73%*** 0.52%*** 0.19% (0.82) (4.87) (5.61) 0.37*** 0.48*** 0.02 (0.12) (3.70) (6.21) 0.45*** 0.46*** 0.22 (1.54) (7.65) (3.45) -0.28** (-2.24) -0.37*** (-3.10) 0.02 (0.15) -0.06 (-0.89) -0.15** (-2.10) 0.15 (1.17) na na na

AllbutFOF: FOFOnly: f-Stat f-Stat Spread Spread 0.01% 0.27%* (0.04) (1.84) -0.08 0.62*** (-0.39) (3.36) 0.20 0.17 (1.14) (0.75) na na na FOFOnly 0.02% (0.11) Relative Value 1.35%*** (4.95) Multiprocess -0.35% (-1.59) na na na

Difference young fundswithpast high alpha f-statistics for minus old fundswithpast low alpha f-statistics Fund groups All Funds AllbutFOF 0.27%** (2.01) Stylecategories(ex FOF) Security Selection 0.58%*** (2.33) Notes:Age was measured in months.See also thenotes to Table 6. na = not applicable. at *Statistically significant the 10 percentlevel. at **Statistically significant the5 percentlevel. at significant the 1 percentlevel. ***Statistically 0.35%** (2.15) Directional -0.25% (-0.50)

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Table 8.

Performance of Portfoliosof Funds Formed on Independent Sorts on Size and Age in (-statistics parentheses)
Size Tercile1 0.34%*** (3.31) 0.28*** (3.18) 0.28*** (2.68) -0.06 (-0.67) -0.05 (-0.46) -0.08 (-0.60) Size Tercile2 0.10% (1.04) 0.21** (2.33) 0.37*** (3.95) 0.27*** (3.15) 0.25*** (2.78) 0.20*** (1.97) Size Tercile3 0.15% (1.46) 0.17* (1.67) 0.21** (2.07) 0.06 (0.89) 0.07 (0.93) 0.01 (0.15) na na na All Funds 0.13%** (2.30) na na na AllbutFOF 0.18%*** (2.75) Relative Value 0.00% (0.03) AllbutFOF: Size Spread -0.23%*** (-2.90) -0.38*** (-4.69) -0.30*** (-2.78) na na na AllbutFOF 0.28%*** (4.24) Relative Value 0.23%*** (2.64) na na na All Funds: Size Spread -0.19%*** (-2.88) -0.11 (-1.59) -0.07 (-0.94) AllbutFOF: Size Spread -0.26%*** (-3.21) -0.10 (-1.27) -0.14 (-1.53) FOFOnly: Size Spread 0.03% (0.30) 0.03 (0.38) 0.12 (1.07)

Grouping A. One-year holding period Age Tercile1 Age Tercile2 Age Tercile3 All Funds age spread AllbutFOF age spread FOFOnly age spread

for Difference small and young minus old and large Fund groups FOFOnly 0.04% (0.43) Multiprocess 0.03% (0.50)

Stylecategories

Security Selection 0.31%*** (3.36)

Directional 0.30% (1.36) AU Funds: Size Spread -0.27%*** (-4.31) -0.35*** (-4.83) -0.18** (-2.05) na na na All Funds 0.25%** (4.32)

B. Two-year holding period Grouping Age Tercile1 Age Tercile2 Age Tercile3 All Funds age spread AllbutFOF age spread FOFOnly age spread Size Tercile1 0.62%*** (6.12) 0.70*** (6.24) 0.57*** (4.59) -0.06 (-0.81) -0.03 (-0.26) -0.13 (-1.26) Size Tercile2 0.33%*** (2.60) 0.51*** (5.77) 0.45*** (4.28) 0.10 (1.16) 0.10 (1.07) 0.03 (0.24) Size Tercile3 0.33%*** (3.38) 0.32*** (3.12) 0.38*** (3.65) 0.03 (0.41) -0.05 (-0.59) 0.19** (2.83) na na na FOFOnly 0.09% (0.88) Multiprocess -0.03% (-0.47) FOFOnly: Size Spread -0.29%*** (-2.61) -0.14 (-1.26) 0.04 (0.36)

Difference small and young minus old and large for Fund groups

Stylecategories

Security Selection 0.56%*** (5.48)

Directional 0.53%*** (2.62)

Notes:Hedge fundswere sortedintoquintileportfolios thebasis of independenttercilesortson lagged 12-month on size (in millions of dollars) and lagged 12-month (in months).Spread is Tercile3 minus Tercile1. age na = not applicable. at *Statistically significant the 10 percentlevel. at Statistically significant the5 percentlevel. at ^Statistically significant the 1 percentlevel.

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Hedge Fund Performance Persistence

Table 9.

Performanceof Portfoliosof Funds Formed on Independent Sorts on Size, Age, and Past Performance in (-statistics parentheses)
One-Year Holding Period Two-Year Holding Period Alpha 0.67% -0.01 0.86% -0.01 0.26% 0.19 Difference . 0.68%*** (4.03) 0.87%*** (4.05) 0.07% (0.36) Alpha 0.63% -0.14 0.59% -0.25 0.60% 0.42 Difference 0.77%*** (4.10) 0.84%*** (3.21) 0.18% (0.78)

Pprtfolio A. All Funds Small, young,past high -statistics Large, old, past low f-statistics B.AllbutFOF Small, young,past good alpha Large, old, past bad alpha C.FOFOnly Small, young,past good alpha Large,old, past bad alpha D. Breakout All butFOF for

Security Selection Difference small,young,past for good alpha minus large,old, past bad alpha: one-yearholdingperiod Difference small,young,past for good alpha minus large,old, past bad alpha: two-year holdingperiod

Directional

Relative Value

Multiprocess

0.92%*** (2.31)

Too few obs

Too few obs

Too few obs

1.19%***

Too few obs

Too few obs

Too few obs

(^85) Notes:Hedge funds were sorted into quintile portfolioson the basis of independenttercilesorts on size (in millionsof dollars), lagged 12-month age (in months),and past performance lagged 12-month of seven-factor (-statistic 36-month alpha). at ***Statistically significant the 1 percentlevel.

For the individual categories of funds in reported PanelD ofTable9,inmostcases,I had in too fewobservations theportfolios formed by sortson age, size, and past perforindependent a For manceto perform meaningful analysis. the basedon the selection however, portfolio, security three sorts, the evidence of persistence is in The difference performance extremely strong. smallfundsand past between past good,young, is bad,old,largefunds 11.6percentage (15.2 points for one-year the (twopercentage points) year per is consistent with year)period.Thisresult largely Kosowski et al. (2007), who found the most sorts for persistence on performance-only selection hedgefunds. security withthe exception the subperiod of Finally, the October 2000 both one-year 1998-December for I and two-year which did not holding periods(for all other detect results persistence), subperiod supthe results. ported full-period A possibleconcern when interpreting these results that is maybe more youngor smallfunds and suchas thefailure to crises, likely failduring
November/December2008

bailout Long-Term of CapitalManagesubsequent of bubble.Ifso, mentor thebursting theinternet that wouldbe then persistence the results I found ratesforthe sixweakened.I comparedfailure month periodaroundbothcrisesand foundno in difference failure ratesbetweensmall and all and all other other funds between or funds, young as where"small"("young")was defined beingin thebottom size (age) tercile. Hence,thisconcern tobe unwarranted. appears Takentogether, results thissection in are the oftheBG model. strongly supportive The model proposedby Berkand Green(2004) that implies performance persistence amongmanshould varywithfundage and aged portfolios fundsize. Because investment flowschase past and becausefunds confacecapacity performance an funds reach optimal (orgo size straints, quickly reduces likelihood perforthe of it), beyond which mancepersistence.
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Financial Analysts Journal

I testedthe implications thismodel on a of of hedge fundsforthe 1994-2004 sample period and foundresults withtheBG consistent largely model:A portfolio young, of small, goodpastpera of formers outperformed portfolio old, large, 10 percentage poor past performers nearly by The wereweakest funds for points year. results per of hedge fundsand strongest single-strategy for funds, hedge funds,and among single-strategy results were strongestfor securityselection funds. long-short) (including Theseresults thosein prior litercomplement inhedgefunds. ature that found Notapersistence bly, Kosowski et al. (2007) foundperformance in of persistence portfolios hedge fundswhen fundswere selectedon thebasis of past performance. results theirs indicate and that My augment funds the offund andfund on basis byselecting age size inaddition pastperformance, to can investors the likelihood superior of substantially improve over basedonpast performance a selection process alone.Also,Fungetal. (2008)showed performance that subset funds hedgefunds alphaand a of of has that in someofthesefunds able to persist the are term. thesehave-alpha short Of funds, however, thosethatreceivedlargeinvestment are inflows in lesslikely persist thefuture those did to than that not.I used theresults from Kosowskiet al. and et al. to designtests examining for whether Fung fundsthatreachtheiroptimalsize (or age) are becauseofincreased investment flows) (probably less likely have performance to in persistence the and I found tobe thecase. this future, I offer following the caveatabout important themainresults thestudy: of the Although empiricalresults that indicate young, smallfunds clearly to aremorelikely exhibit performance persistence thantheir the universe hedge of peers, observable funds excludes young funds didnotmake that very itpasttheincubation the stage.I adjusted data to accountforthisincubation periodin fundsthat but survived, thedata do excludefundsthatdid notsurvive. of Hence,theresults thisstudymay notholdfor funds. start-up Investors cannotuse the exactmethodology used in thisstudy(creating long-short a portfolio

of hedge funds)because investors cannotsell a fund butthey benefit selecting can short, hedge by on hedge fundsforinvestment the basis of the in findings this study. In particular, selecting with smallhedgefunds young, strong perforpast the manceappearstogiveinvestors bestchance of in outperformancethefuture.
I wishto thank VikasAgarwal,Mike Cooper, Roberto AndrewKarolyi,Narayan Guiterrez, JeanHelwege, Naik,RenStulz,and KarenWruck.
This for article qualifies 1 CE credit.

are These definitions based on those of Credit Suisse/TASS. The investment Long/short equity: manager in takeslongand short positions equities. Pureemerging market: fundinvests The excluin emerging market debtor equity. sively Emergfundsare theonly"longonly"funds ing market in listed theTASSdatabase. Eventdriven: The investment managertypiin takes orshort or cally long positions equities debt in instruments anticipation an event, of suchas a or venture, corporate restructuringa planned joint in expectation a substantial of price movement whentheevent occurs. Globalmacro: The investment manageruses fundamental technical to and/or analysis establish inanypublicly directional traded market positions aroundtheworld. Convertible The arbitrage: investment manager establishes simultaneously long and shortpositionsin different forms convertible of securities from same corporate the issuerand, in so doing, inefficiencies between differthe captures pricing entsecurities. The manFixed-income arbitrage: investment in agerestablishes and short long positions related debtsecurities derivative or instruments.

Appendix A. InvestmentStyle Categories

Notes
1. See, forexample, Agarwal and Naik (2000); Baquero, ter Horst,and Verbeek(2005); Brown,Goetzmann,and Ibbotson (1999); Brown, Goetzmann, and Park (2001); Gyger, Gibson,and Bares (2003); Naik and Agarwal (2000). in to My articlecontributes fairlyrecentliterature hedge have been studying funds,but academics and practitioners persistencein mutual funds and pension funds formany (1968) foundno supportfor years.An earlystudyby Jensen over5-year 10to persistence. Papers supporting persistence and Gruber, Blake(1996), yearperiodsincludethoseofElton, and Elton,Gruber,Das, and Mavka (1993), and Grinblatt Titman(1992),who attributed persistence managers' this to stock-picking ability.Support for one-year to three-year persistence comes from Brown and Goetzmann (1995),

2.

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Hedge Fund Performance Persistence

3.

4.

5. 6.

and Goetzmann Ibbotson Hendricks, andZeckPatel, (1994), hauser and Carhart (1993), Wermers (2000). (1997)showed that one-year the momentum ofJegadeesh Titman effect and for (1993)accounts muchof theperformance persistence found Hendricks al.andthat et inmutual differences fund by an trading costscan explain all expenses nearly of the and Ferson, Glassremaining persistence. Christopherson, man(1998) conditional evaluation a to applied performance and funds showedthat conditional the sampleofpension is and able to detect approach better persistence predict than future methods. (linear) performance "unconditional" The persistence found was concentrated they amongthe worst with performers. Recently, a Bayesian using approach fund and and Busse data,Bollen Busse(2005) dailymutual and Irvine evidence quarterly of (2006)found performance that persistence is notexplained momentum. by Another contribution Kosowski al.(2007) ofthe et important article theuse ofBayesian is in which, addition techniques, toselecting funds thebasisofIRs,greatly on the improves of I did probabilityfinding performance persistence. notuse the which biasesagainst Bayesian technique, finding persistencewhenmymethodology followed. think my is I of as or to as approach an alternative complement theirs, one that be accessible ordinary to investors. might more Clearly, in using the Bayesian methodology addition to my shouldfind evenmore than approach persistence I found. Thiscombined is the approach beyond scopeofmyarticle. Kosowski al. (2007) perform et did additional todetertests minewhether fund flows size are related to and/orfund these tests not main were the focus of persistence, although their article. withmyresults, Consistent foundthat they withabove-average funds investment flows had less perIn sistence. contrast myresults, to did however, they not find link a between andperformance size This persistence. could be a result differences the in of contrary finding of test on designs their and mytest(they splitfunds the basisofmedian size rather thanintosize terciles put and funds performance in thanin quintiles), a decilesrather in differencetime data whereas (their endin2002, periods a in and/or differencesample(their mydataendin2004), threedatabases;I used only the sample encompassed Tremont Shareholder Services database). Advisory TASShas maintained on dead funds data since1994. I calculatedalphas over rolling 36-month periods,but because return were data to occasionally missing, maximize the ofthe size I that haveatleast sample,required eachfund 24 ofthe36 returns a during given36-month periodtobe in included theanalysis. also performed for the I tests all in for The analyses thestudy a three-year holding period. results thethree-year for are staholding period generally no of (i.e., tistically insignificant I found evidence persisand nature the of portfolio-formation tence), becauseofthe sorts fundage and/orsize and on process(independent in portfolios often observationsthe were pastperformance), toofewfor toperformmeaningful me a analysis.

7. Theinitial for contained 3,333 sample theformation period funds. The sampleforthe evaluation periodwas 2,500 funds. Fundsleft samplebecauseofmissing the data for or failed. size,age,orflow whenthey 8. See Brown,Goetzmann,Ibbotson,and Ross (1992); Carhart (1997). 9. Using did actual returns notsignificantly the change results ofanyofmyanalyses. 10. Fung and Hsieh's (2004) seven-factor model has been It widelyused in thehedgefundliterature. includesas a of factors regressors number asset-based designedto mimic common a market and factor, hedgefund strategies, a size-spread factor. further For detail, pleasesee theoriginalarticle. 11. Thesesubperiods as defined Funget al. (2008).For in are I do the but are on brevity, notreport results, they available The are with results fairly consistent the request. subperiod results thefull for sample period. 12. The rationale performing for sortswas to independent increase power thetests. a fund be included the of For in to the"pastgood,pastsmall" it for portfolio, example, hadto be bothin thetopquintile performance also in the of and bottom tercile size.Because alonecanpredict of size perforwill disproportionately the of mance, top quintile funds include smaller and sorts funds, conditional onthis portfoliowillnotreveal much the dispersion among sizeterciles. In contrast, tests of my required independent membership eachofthesizeandperformance Of this portfolios. course, also that approach has thepossibility thesamplesize in a couldbe zero (ifthere no independent is givenportfolio whichdid happenoccasionally certain for fund overlap), and whenitoccurred. styles, I havenoted 13. Althoughfound I weakresults funds funds that in for of the effects fund and fund werenotas important of size as age werefor should not funds, finding they single-strategy this be taken evidence theBG modeldoes notholdfor that as funds funds. fact, of In evidence Funget al. (2008)found that BGmodel the doesholdfor funds funds. of Specifically, chase performance in theyfoundthatflows(rationally) funds hedgefunds havepositive of that risk-adjusted performance. Because theincreased of the inflows, probability of finding funds persistence among these high-flow decreases.My finding does not contradict theirs, but, it in the fund rather, notesthat thecrosssection, optimal size(age)inthe FOFspacedoesnotappear haveyet to been reached. Thisresult plausible a number reasons: is for of the size of in was First, average offunds funds mysample of $109million thesmallest anyassetcategory. Second, funds funds invest a number different of in can of styles, which that fund for FOFportfosize an implies theoptimal liois likely be higher for to than other because Third, styles. these fundsinvestin otherfunds,the impactof age described Berk Green and hat (2004) namely, as funds by tendtoinvest more age,they passively shouldnotbe as relevant itis for as funds. single-style

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