Hedge fund styles in the financial crisis

Abstract

This study aims to examine the difference in performance between hedge fund styles during the 2007 financial crisis. While it is perceived that hedge funds aim to follow a market-neutral investment style, hedge funds today are a very heterogeneous group when it comes to their strategies. Additionally, performance studies in hedge funds are known for hefty self-selection biases, namely survivorship and look-ahead bias, both of which are expected to be more vigorous in a bad economy. By removing database biases and correcting reported returns for survival and look-ahead bias, this paper aims to study whether certain investment styles outperformed others during the financial crisis in 2007-2010. The objective of this study is threefold. Firstly, this paper aims to study the extent to which the raw database reports were upwards biased during the crisis period due to self-selection biases. Secondly, this paper studies hedge fund's performance persistence and tests whether reported returns exaggerate their true ability to perform. Finally, these results will be interpreted style specifically to see whether there are significant differences in performance patterns between styles. I find the reported returns to be exceedingly skewed during the financial crisis together with record-high attrition level. After correcting for self-selection, the left tail returns were much lower than reported returns. While positive returns on average were only mildly over reported, poor returns were statistically significantly more than 17% lower after excluding biases from the database. Short-term performance persistence was found even during financial crisis, however, this effect diminished over time. On average, the best performing funds had the same likelihood to continue to perform extremely good as well as extremely bad. After adjusting for database biases, performance persistence weakened furthermore. However, performance persistence varied wildly between investment styles. During the financial crisis period 2007-2010, Multi-strategy funds outperformed all other styles measured in absolute returns and came in second on risk-adjusted basis. Moreover, Multi-strategy funds' showed lower attrition, more performance persistence than other funds, and frequently appeared as a top performing fund. Global Macro also performed relatively well during the financial crisis and reported highest risk-adjusted returns after correcting for database biases. Fund of funds, on the other hand, clearly underperformed all other style during the financial crisis, as they failed to generate returns and exhibited no persistency in performance. Despite of self-selection biases, a thorough analysis can help an investor to choose the appropriate fund to invest in, while styles remain a crucial part in determining the success of the fund.