The Persistence of Hedge Fund Risk

Abstract

In this article the authors examine persistence of hedge fund performance and find that returns are not persistent while risk (volatility in returns) and correlations to underlying markets are highly persistent. Less risky funds tend to be less correlated with underlying markets and more efficient at bearing risk than their more risky counterparts. They analyze various determinants of hedge fund performance and develop a multifactor model to identify funds whose superior performance is based on underlying investment skill, rather than on risk-taking or undue exposure to markets. For the period 1996 to 2001, portfolios of such funds generate significantly higher risk-adjusted returns (Sharpe ratio of 4.14) than portfolios containing all funds (1.38), portfolios constructed solely on the basis of past returns (0.75), and portfolios constructed based on past Sharpe ratios (2.42).