Persistent Doubt: An Examination of Hedge Fund Performance

Date01 September 2016
Published date01 September 2016
Persistent Doubt: An Examination of
Hedge Fund Performance
ıa de la O. Gonz
School of Economic& Business Sciences, University of CastillaLaMancha, Plaza de la Universidad 1,
02071, Albacete, Spain
Nicolas A. Papageorgiou
HEC Montreal, 3000 Cote Ste Catherine, Montreal, H3T2A7, Canada
Frank S. Skinner
Department of Economics and Finance, Brunel University, Uxbridge, London, UB8 3PH, United
We examine whether performance persistence is suspicious. Top quintile portfolios
formed on the Sharpe ratio, alpha, and information ratio persistently outperform
similarly constructed mediocre third quintile portfolios throughout our sample
period, but performance is more modest and less persistent when portfolios are
formed on the excess manipulation-proof performance measure (EMPPM). By
selecting funds formed on ranking by Sharpe and information ratios, investors also
select funds that have persistently doubtful performance according to the doubt
ratio. In contrast, portfolios formed on alphas and especially the EMPPM have
much less excess and persistent doubt.
Keywords: hedge funds, performance measures, manipulation-proof performance
measure, doubt ratio
JEL classification: G1, G11, G23, G24
We thank the Editor (John Doukas) and an anonymous referee for excellent comments and
suggestions. We are also grateful to Ephraim Clark, Richard McGee, Frank McGroarty,
Thomas and Julia Henker, the seminar participants of the Adam Smith Seminar Series, and
the conference participants of Infinity and FEBS for their helpful comments. We use hedge
fund risk factors from David A. Hsiehs data library and gratefully acknowledge David A.
Hsieh for making these data publically available. This work was supported by Junta de
Comunidades de CastillaLa Mancha and Ministerio de Econom
ıa y Competitividad (grant
numbers PEII-2014-019-P and ECO2014-59664-P, respectively). Any errors are the
responsibility of the authors.
European Financial Management, Vol. 22, No. 4, 2016, 613639
doi: 10.1111/eufm.12070
© 2015 John Wiley & Sons, Ltd.
1. Introduction
Hedge fund performance and performance persistence are a controversial issue. Many
authors, such as Ammann et al. (2013) and Boyson (2008), nd that hedge funds
persistently deliver positive alphas out of sample. Other research is more critical,
claiming that performance persistence depends upon the measure used (Capocci et al.,
2005), that performance persistence is attributable to passive investments in illiquid
assets (Brandon and Wang, 2013), and even that performance persistence for top funds
does not exist at all (Slavutskaya, 2013). Recently, Dichev and Yu (2011) document a
sharp reduction in buy and hold returns for a very large sample of hedge funds and
commodity trading advisors, from 18.7% from 1980 to 1994 to 9.5% from 1995 to 2008.
Clearly, there are doubts concerning the performance, performance persistence, and
measurement of the performance of hedge funds.
Meanwhile, Goetzmann et al. (2007) demonstrate that common performance
measures such as the Sharpe ratio, alpha, and information ratio can be subject to
manipulation, deliberate or otherwise. To address this issue, the authors develop a
manipulation-proof performance measure (MPPM), so called because it is robust to the
underlying return distribution and to gaming by hedge fund managers. Additionally,
Brown et al. (2010) develop the doubt ratio. This measure is a diagnostic statistic derived
from the MPPM and indicates whether the reported returns from hedge funds are
suspicious. Together, the MPPM and the doubt ratio allow us to examine recent hedge
fund performance and shed light on whether top hedge funds achieve superior
performance, whether this performance persists, whether performance persistence is
doubtful, whether doubts concerning hedge fund performance persist, and whether
performance persistence is down to skill, manipulation or luck.
We test for persistence in hedge fund performance by forming portfolios according to
ve different performance measures that are further stratied by quintile and strategy.
The ve measures are the Sharpe ratio; the alpha from Fung and Hsiehs (2004) hedge
fund asset pricing model augmented by an eighth factor for emerging markets; the
information ratio, obtained as the t-statistic from Fung and Hsiehs alphas; the MPPM of
Goetzmann et al. (2007); and the doubt ratio of Brown et al. (2010). The Sharpe ratio,
information ratio, and alpha enable us to compare our results with the recent literature
and allow us to highlight how the picture changes when we evaluate the performance and
performance persistence of top quintile hedge funds with the MPPM and doubt ratio.
Each portfolio is formed monthly, between January 31, 2001, and December 31, 2010,
using the prior months performance and performance is tracked fortwo years. We thus form
120 overlapping out-of-sample portfolios for each strategy and quintile, each of which is
held for 2 years. This ensures that we only use information available on the date that the
portfolios are formed so that our subsequent examination of monthly out-of-sample
performance mimics the investment activities of portfolio managers. We then test for
superior performance using bootstrap t-tests.
This testing strategy allows us to address several questions. Do hedge funds deliver
consistent superior performance, on average, throughout the sample period and in the
bull and bear markets around the December 31, 2006, pivot date? Can top-performing
hedge funds persist in delivering superior performance? If so, for how long will this
superior performance persist? Are the answers to these questions sensitive to the choice
of performance measure? Specically, is there any evidence that the hedge fund industry
manipulates common performance measures? Is the newly developed MPPM resilient to
© 2015 John Wiley & Sons, Ltd.
614 Mar
ıa de la O. Gonz
alez, Nicolas A. Papageorgiou and Frank S. Skinner

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