Performance Persistence: Is It There, And Can It Be Exploited?

By the end of 2020, only 0.72% of all active US mutual funds had finished in the top quartile every year since 2016. Among mutual funds, mid-cap funds displayed the highest degree of persistence: 1.47% of them have finished in the top quartile for five consecutive years. The figures are equally disappointing in terms of absolute performance: only 7% of large-cap mutual funds have outperformed their benchmarks over the past 20 years on a volatility-adjusted basis. For mid-cap and small-cap funds, the figures are 14% and 12%, respectively.[1] Given the rise of passive equity investment products, these figures do not surprise most investors. How about hedge funds?

Performance Persistence: Is It There, and Can It Be Exploited?

Using the CISDM hedge fund database, I examined the relative volatility-adjusted annualized performances of hedge funds. Since 2010, only 4.8% of the hedge funds have been ranked in the top quartile more than half of the time. By the way, a 60/40 portfolio of equities/bonds would have been ranked in the top quartile 28% of the time.

Exhibit 1 shows the percentage of hedge funds that displayed significant persistence between 2000 and 2017. Note that persistence here covers both consistent “winners” and “losers.” For example, about 40% of funds consistently performed better or worse than their peers in the short run. As we move to 36 months in the future, the percentage of funds displaying persistence declines significantly. Only 15% of them displayed persistence after 36 months. More importantly, more than 60% of persistence cases are due to those funds that performed poorly. It turns out that it is easier to be consistently bad.

In short, the sample of funds that consistently perform well is tiny. More importantly, persistence almost disappears after 36 months, which means that investors who want to take advantage of this property must be willing to turn over their hedge fund portfolio every 3-4 years. Another critical point to remember is that the degree of persistence among funds of funds is roughly the same as hedge funds.

Exhibit 1: Percentage of hedge funds that display performance persistence (Source: CISDM)

Using the CISDM database, I recreated Exhibit 1 for various strategies. The results are displayed in Exhibit 2. We can see that the degree of persistence varies by strategy, and a few of them display strong persistence and minimal drop-off at longer horizons. For example, about 40% of merger arbitrage managers display strong persistence for at least 36 months. The same applies to multi-strategy, where about 30% of funds display strong persistence.

On the other hand, some strategies display strong performance only at short horizons. Other studies have shown that fund managers with a distinct approach to a given strategy are more likely to display persistence. For instance, a convertible arbitrage manager who employs a unique strategy implementation is more likely to display persistence – good or bad. How about private equity?

Exhibit 2: Percentage of Funds Displaying Persistence by Strategy (Source: CIDM)

Measuring persistence in private equity (i.e., buyout and venture capital) is far more challenging. First, it is not very helpful to examine private equity funds’ quarterly or annual performances because it is nearly impossible to have any turnover in a portfolio of private equity investments. Second, until a fund is almost entirely liquidated, the reported returns are highly unreliable and subject to significant smoothing. Finally, the presence of the J-curve creates predictable patterns in cash flows and returns, distorting any attempt to measure persistence in periodic returns. For these reasons, persistence is measured by comparing 5-7 year returns from different funds. Naturally, this approach significantly reduces the number of observations that each manager could potentially have.

With this caveat in mind, we can report some of the recent findings on the performance persistence for private equity firms. Note that to avoid any biases related to interim reported returns, we must wait until a fund is liquidated to use the return realized by investors. This means that the most recent year that one can study is likely to be several years ago.

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