Article: Luck versus Skill in Evaluating Hedge Fund Managers' Performance Journal: Journal of Business and Management (JBM) 2020 Vol.26 No.1 pp.22 - 39 Abstract: Purpose - The purpose of this paper is to examine if excess returns produced by hedge fund managers are due to luck or skill. Method - False Discovery Rate (FDR) method addresses the question of how manager skill, as opposed to luck, affects abnormal risk-adjusted return performance of actively-managed funds. This study uses the FDR method to separate hedge fund managers into one of three groups: a) Skilled; b) Unskilled; and c) Zero-alpha (i.e., neutral). After identifying skillful hedge fund managers, the Fung-Hsieh benchmark model is used to understand the source of excess returns. Findings - After analyzing hedge fund monthly returns from 1999 to 2012 using the FDR method, only 2.68% of managers of hedge funds are found to be truly skilled, 33.20% are unskilled, and the rest are managers of zero-alpha funds. There is evidence to suggest that skillful fund managers are better at using emerging markets, foreign exchange, and commodities compared to unskilled managers. Limitations - This study is restricted to hedge funds. Further studies may include participants from other alternative investments (i.e., private equity, real estate) to see if skill exists in other alternative asset classes. Implications - Investors pay a significantly higher fee to hedge fund managers, hoping that the manager has skill in producing higher risk-adjusted returns. Therefore, investors (such as public pension funds) need to know if a manager is producing any excess returns due to luck or skill. Originality - Luck versus skill debate has raged on for over three decades in the mutual fund segment. This paper extends this debate to the hedge fund segment. Besides, this paper applies the FDR method, initially intended for use in Biological Sciences, to evaluate hedge fund performance. Inderscience Publishers - linking academia, business and industry through research

Title: Luck versus Skill in Evaluating Hedge Fund Managers' Performance

Authors: Rama K. Malladi

Addresses: Author address listing can be found in the "About the Authors" section at the end of the article.

Abstract: Purpose - The purpose of this paper is to examine if excess returns produced by hedge fund managers are due to luck or skill. Method - False Discovery Rate (FDR) method addresses the question of how manager skill, as opposed to luck, affects abnormal risk-adjusted return performance of actively-managed funds. This study uses the FDR method to separate hedge fund managers into one of three groups: a) Skilled; b) Unskilled; and c) Zero-alpha (i.e., neutral). After identifying skillful hedge fund managers, the Fung-Hsieh benchmark model is used to understand the source of excess returns. Findings - After analyzing hedge fund monthly returns from 1999 to 2012 using the FDR method, only 2.68% of managers of hedge funds are found to be truly skilled, 33.20% are unskilled, and the rest are managers of zero-alpha funds. There is evidence to suggest that skillful fund managers are better at using emerging markets, foreign exchange, and commodities compared to unskilled managers. Limitations - This study is restricted to hedge funds. Further studies may include participants from other alternative investments (i.e., private equity, real estate) to see if skill exists in other alternative asset classes. Implications - Investors pay a significantly higher fee to hedge fund managers, hoping that the manager has skill in producing higher risk-adjusted returns. Therefore, investors (such as public pension funds) need to know if a manager is producing any excess returns due to luck or skill. Originality - Luck versus skill debate has raged on for over three decades in the mutual fund segment. This paper extends this debate to the hedge fund segment. Besides, this paper applies the FDR method, initially intended for use in Biological Sciences, to evaluate hedge fund performance.

Keywords: Hedge fund; false discovery rate; FDR; performance evaluation; luck; skill.

DOI: 10.1504/JBM.2020.141278

Journal of Business and Management, 2020 Vol.26 No.1, pp.22 - 39

Published online: 05 Sep 2024 *

Title: Luck versus Skill in Evaluating Hedge Fund Managers' Performance

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