New study finds no evidence of outperformance by hedge fund 'best ideas'

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”. 

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.

That's the findings of a new report by Epsilon Asset Management, a quantitative asset management firm that pursues bottom-up stock-selection alpha through a data science investment approach.

The report – Hedge Fund Alpha and their Best Ideas – which was produced in collaboration with New York University (NYU) – was co-authored by Epsilon partners Faryan Amir-Ghassemi and Michael Perlow with NYU's National Science Foundation award-winning assistant professor of finance and risk engineering Andrew Papanicolaou. 

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 report reveals new scientific and academic evidence of true stock picking skill across the spectrum of hedge fund managers, but no systematic outperformance of Best Ideas versus other portfolio positions held by hedge fund managers, across all size funds, and over all time periods. In addition, the results of the study infer 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,” says 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,” says 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.”