Hedge fund managers’ propensity to trade does not correlate cleanly with higher or lower investment returns, researchers have found.
“A priori, it is not clear whether the after-fee performance of the more active funds should exceed those of the less active funds,” Maziar Kazemi of the Federal Reserve System and Vassar College’s Ergys Islamaj wrote in “Returns to Active Management: The Case of Hedge Funds.”
In theory, given equal skill levels or efficient markets, managers incurring lower transaction costs should outperform their more active peers on a net basis.
However, in examining the performance and portfolio churn of more than 2,600 equity long-short hedge funds, the researchers found a nonlinear relationship between activity level and returns. Indeed, the correlation reversed depending on how performance was measured: in raw or risk-adjusted returns.
“The most active managers have to overcome the higher levels of transactions costs, and therefore, only those who are highly skilled can offer higher risk-adjusted return,” –Maziar Kazemi and Ergys Islamaj.
The study—based on a data from 1994 to 2013—first found moderately active funds on average earned higher absolute returns than more static managers. But only up to a point: When portfolio turnover exceeded a certain threshold, returns fell behind those of patient managers.
The lower returns of highly active funds could be attributed to higher transaction costs, the authors said. They attributed moderately active funds’ superior outcomes to skill: These managers tended to assume more risk than their more passive counterparts while incurring average costs.
Yet when the authors measured on a risk-adjusted basis, their results inverted: On average, slow and steady investing won the race.
This disparity in the relationship between returns and portfolio activity could be explained by the nature of managers, the study said. For example, managers preferring to buy-and-hold act more as long-term stock pickers, able to “generate better risk-adjusted performance without frequently changing their portfolios’ risk exposures.”
The paper noted that highly active managers’ performance was widely distributed while the returns from more passive peers tended to cluster more closely.
“The most active managers have to overcome the higher levels of transactions costs, and therefore, only those who are highly skilled can offer higher risk-adjusted return,” wrote Islamaj and Kazemi. “Only a small group of equity long-short managers possess that level of skill.”
Read the full paper here.
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