A-B-C (Alpha-Beta-Churn) of Equity Picks by Institutional Investors and Robust Superiority of Hedge Funds

Abstract

The empirical literature on investment performance suggests that hedge funds have delivered overall superior performance. We examine whether their superiority, both absolute and relative to other institutional investors, continues to hold when we focus purely on their long-equity holdings. We find that the long-equity holdings of hedge funds exhibit a reliable excess return of 4.1% per year, which contrasts with the normal lower excess-returns-to-active-stock-picking for other institutional investors. The long-position superiority is mostly delivered by the larger hedge funds and is concentrated in some industries. Hedge funds churn their holdings much more than other institutional investors and indexers, suggesting that hedge funds may load more heavily on liquid stocks that offer lower trading costs (which include transactions costs and inelastic supplydemand costs). We also find that high churn rate and high active shares are consistent with superior returns for hedge funds. The stock-picking superiority of hedge funds persists across the different market regimes (bubble, deflation, and recovery) of our sample period of 1997 to 2006.