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Matthias Knab, Opalesque for New Managers: A new paper "Unobserved Performance of Hedge Funds', authored by Vikas Agarwal, Stefan Ruenzi, and Florian Weigert, is forthcoming at the Journal of Finance.
The paper finds that over the period from 1997 to 2017, hedge funds have earned substantial alpha (outperformance against their benchmark) based on their reported returns. However, when investigating their disclosed long equity portfolio data, the alpha is not there. Interestingly, the authors found that hedge funds' "unobserved actions" - i.e., frequent trading, derivatives usage, short selling, and confidential holdings - account for a large part of their alpha. The paper continues classifying the performance stemming from these activities as UP (unobserved performance) and shows that UP is a strong predictor of future hedge fund performance.
Outperformance of 6.36% p.a. based on unobserved performance
Firms with high UP outperform those with low UP by 6.36% p.a. on a risk-adjusted basis. UP is negatively associated with a firm's trading costs and positively associated with intraquarter trading in equity positions, derivatives usage, short selling, and confidential holdings. In addition, limited investor attention can delay investors' response to UP and lead to longer-lived predictability of fund firm performance.
The SSRN version of the paper can be...................... To view our full article Click here
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