ADD or Value-Add? Hedge Funds’ Ideal Activity Level

Highly active fund managers tend to outperform those who buy-and-hold in absolute returns, but researchers found that adjusting for risk reversed their results.

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.

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“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.

Credit rating agency Fitch has downgraded New Jersey’s municipal bonds for the second time this year, citing continued deterioration of the funding levels of the state’s pension funds.

The bonds have been cut from A+ to A, leaving them among the worst-ranked municipal bonds in the US.

“Fitch believes balancing the need for requisite pension system contributions with other long-term demands… will continue to prove difficult.”—Fitch RatingsNew Jersey has “above average” outstanding debt obligations, Fitch said, which include contributions to the state’s public employees’ retirement system (PERS) and the teachers’ pension and annuity fund (TPAF). At the start of July 2013, New Jersey said PERS was 62% funded while TPAF was 57% funded. But Fitch, using a more cautious valuation assumption, said the levels were roughly six percentage points lower.

“Continued pension funded ratio deterioration is projected through the medium term and full actuarial funding of the required contributions is several years off,” Fitch said in a statement.

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The rating agency added that a suspension of planned contributions for the 2014 and 2015 fiscal years, announced by Governor Chris Christie earlier this year, was likely to further erode pension funded ratios.

It concluded: “Fitch believes balancing the need for requisite pension system contributions with other long-term demands, such as infrastructure needs, property tax relief, and school funding, will continue to prove difficult.”

The three main credit rating agencies—Fitch, Moody’s, and Standard & Poor’s (S&P)—cut their ratings of New Jersey’s debt in April. The state was warned of a possible further downgrade by S&P in June, following news of Governor Christie’s plans to cut contributions to PERS from $3.8 billion to $1.4 billion.

The downgrade puts New Jersey one notch above Illinois on Fitch’s scale, with the mid-western state’s debt rated the lowest of any US state.

Illinois was also dealt a blow last week by Moody’s, which published a report warning the state that it faced “daunting” challenges relating to its pension funding. Although pension reforms could ease this pressure if passed by the Illinois Supreme Court, the amount of unfunded liabilities in the state’s pensions means bridging this gap will remain challenging “for many years”, the rating agency said.