Invest Person

Academic Study By Epsilon Asset Management and NYU Finds No Outperformance By Hedge Fund Industry’s “Best Ideas”

New, detailed research report looked at 20 years of hedge fund stockpicking

Hedge fund long portfolios were found to consistently generate alpha against the broader market

Best Ideas were not found to outperform the rest of their portfolio positions

Utility of “Best Idea” conferences and dinners called into question

Q1 2020 hedge fund letters, conferences and more

Invest Person

NEW YORK, May 4, 2020 — Epsilon Asset Management (“Epsilon”), a quantitative asset management firm that pursues bottom-up stock-selection alpha through a data science investment approach, today announced the findings of its new report, “Hedge Fund Alpha and their Best Ideas”. Produced in collaboration with New York University (NYU), the study finds hedge fund “Best Ideas” have not outperformed the rest of their portfolios, despite the identification of statistically significant outperformance (“alpha”) by those portfolios against the broader marketplace for a period of 20 years.

Epsilon partners Faryan Amir-Ghassemi and Michael Perlow co-authored the report with National Science Foundation award-winning assistant professor of finance and risk engineering Andrew Papanicolaou of NYU. The study examined the publicly reported portfolio positions of nearly 1,500 hedge funds from 1999 to 2018 to quantify the stock picking skill of these vaunted managers, and to see whether their Best Ideas truly outperformed the market and deserve the attention they generally receive in the media and at industry events. The full report can be seen here.

Key Findings:

  • New scientific and academic evidence of true stock picking skill across the spectrum of hedge fund managers
  • No systematic outperformance of Best Ideas versus other portfolio positions held by hedge fund managers, across all size funds, and over all time periods
  • A strong inference that the incentive fee portion of a hedge fund manager’s compensation dissuades the manager from seeking wealth solely through asset accumulation

The evidence developed by the report broadly suggests that hedge fund Best Ideas do not outperform the rest of their portfolio positions, contrary to both popular belief and comparable studies on mutual funds.

“The message here for investors is that if you are pitched a ‘Best Idea’ by a hedge fund, you need to see the evidence and substantiation of outperformance for yourself,” said Amir-Ghassemi. “With industry conferences and dinners devoted to identifying the supposed best bets of active management, our study is a clarion call about the importance of understanding hedge fund portfolio construction and how a fund is assessing risk and sizing investment decisions.”

“With a rigorous look across a broad spectrum of the industry for two decades, and employing a variety of quantitative methodologies, the evidence was clear,” said Papanicolaou. “While hedge funds can rightly boast of stock picking skill, the notion that ‘Best Ideas’ show any statistical outperformance against the rest of their portfolios was simply not supported by our findings.”

By looking at two distinct periods of recent history, 1999-2009 and 2009-2018, the study uncovered two further warnings for investors:

  • The size and growth of the hedge fund industry has had a deleterious effect on alpha generation
  • The presence of a bull or bear market has important implications for hedge funds’ ability to generate alpha

Additional findings:

  • In the past 20 years, hedge funds have generated 250 basis points (2.5%) of annualized alpha across their long domestic stock picks
  • Generally speaking, smaller firms generated more alpha over the period than larger firms
  • Alpha was demonstrably greater from 1999 to 2009 than from 2009 to 201
  • Over time, alpha has decayed in tandem with the rise of hedge fund assets.
  • Active management still produces real value, specifically when overseen by incentive-fee managers

About “Hedge Fund Alpha and their Best Ideas”

The authors Faryan Amir-Ghassemi, Michael Perlow and Andrew Papanicolaou, PhD (NYU) tested how a portfolio comprised of the Best Ideas from each hedge fund manager would have performed each quarter over twenty years. The analysis covered nearly 1,500 fund managers. The report’s unique process avoids some of the biases associated with traditional returns database analyses (survivorship bias, inclusion bias, incubation bias). For the full report, please see here.

About Epsilon Asset Management

Epsilon is a quantitative investment firm providing boutique solutions to institutions and family offices. Its research process focuses on bottom-up stock selection through a systematic process, predominantly in domestic equities. Epsilon’s investments aim to provide the compelling aspects of passive investing – low fees, transparency, liquidity – with the pursuit of active alpha generation. Learn more at https://www.epsilonmgmt.com/research.


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