Global Hedge Funds: Risk, Return, and Market Timing

We examined the performance of 115 global equity-based hedge funds with reference to their target geographical markets in the seven-year period 1994–2000. Several results are noteworthy. First, global hedge fund managers do not show positive market-timing ability but do demonstrate superior security-selection ability; the Jensen's alphas we found, before and after controlling for market timing, are sizable and positive. Second, incentive fees and leverage both have a significant positive impact on a hedge fund's risk-adjusted return (as demonstrated by Sharpe ratios and Jensen's alphas) but not on a fund's “selectivity index” (i.e., its performance after controlling for market-timing effects). Third, incentive fees can lower the hedge fund's up-market and down-market systematic risk. Fourth, the size of a hedge fund is consistently related to its return performance. Finally, contrary to the general perception, leverage does not significantly affect the systematic risk of hedge funds. We used the monthly returns of 115 global equity-based hedge funds for 1994–2000 to investigate the impact of hedge fund characteristics on the risk, return, security-selection ability, and market-timing ability of hedge funds conditioned on their target geographical markets. The typical analysis of hedge fund performance is carried out according to fund style without reference to the appropriate market benchmark. Research conditioned on the funds' target markets enabled us to refine assessment of hedge fund performance. We evaluated only those equity-based funds that detailed their investment allocations specified in the Managed Account Reports database, which identifies target markets for five groups of global hedge funds—global emerging, global established U.S. opportunity, global established European opportunity, global international (world ex United States), and global macro (world). For our analysis of market timing, we used two models for comparison. Model 1 is the traditional capital asset pricing model, which served as the base model. Model 2 is a market-timing model designed to separate portfolio managers' broad market (or macro) forecasting ability (market-timing ability) from their micro-forecasting (security-selection) ability. The results when we used the market-timing model indicate that, in general, global hedge funds do not have market-timing ability. In fact, a high percentage of hedge funds in the sample, particularly the funds targeting U.S. and developed European markets, had negative timing ability. Global hedge funds appear to have good security-selection ability. The Jensen's alphas we found before and after controlling for market timing are sizable and positive. When we considered the determinants of performance, we found that incentive fees have significant positive effects on the Sharpe ratio and Jensen's alpha but not on our “selectivity performance index,” which measures performance after controlling for market-timing effects. The leverage ratio had effects on performance measures similar to those of incentive fees. In addition, we found incentive fees to be associated with a reduction in overall systematic risk, up-market risk, and down-market risk. The size of a hedge fund was consistently related to its return performance on a before- and after-market-risk-adjustment basis. Our results imply that large funds benefit from economies of scale or that better managed hedge funds attract more investments. Fund age was significant only for market-timing performance; we found that younger hedge funds were able to time the market better than older funds.