By Irene E. Aldridge and Steven F. Krawciw -- Staying in the fund game is no small achievement. What drives the longevity of hedge funds?
Research shows that strong monthly returns are statistically the single strongest predictor of survival. Interestingly, assets under management have little impact on survival rates across time and fund categories.
In the early 1990s, hedge funds rarely if ever went bust. The survival rates were astounding: Over 90% of the funds in the sample survived during the five years between 1991 and 1995.
By contrast, the late 1990’s were anything but stable. Tipped by the Asian banking crisis in 1997 and the Long-Term Capital Management collapse in 1998, hedge funds disappeared in large numbers. Retail funds experienced the greatest rate of attrition: 46% did not make it through the turbulent 1995-2000 period. High net-worth funds did not fare much better. Institutional funds, on the other hand, navigated the LTCM maelstrom with relative success.
During the last five years, institutional players have lost their status as the most resilient group. High net-worth funds led with 77% survival period, versus 69% survival for institutional funds and 64% for retail offerings.
Careful examination of factors that drive survival explains these trends in longevity. AUM levels do not make or break a fund. Instead, the success of the fund is largely determined by good old-fashioned performance: higher average returns and lower standard deviation.
Even in the performance department one size does not fit all fund categories and time periods. In the early ‘90s, only returns significantly mattered to the survival of retail and high net-worth funds. Institutional funds enjoyed a statistically untamed reign where even performance did not matter for their survival.
As shown in Table 1, between 1990 and 1995, an increase of 1% in the average monthly return of a retail fund resulted in a 1.95% increase in the fund’s probability of survival through the end of 1995. A 1% increase in average monthly return of a high net-worth fund led to a 2.24% increase in survival odds.
Amid the financial crises of the late 1990s, low return volatility became a statistically significant factor for prolonging the life of funds. With 99% confidence, a 1% decrease in a fund’s standard deviation of monthly returns led to a 0.89%, 0.90% and 1.28% increase in the probability of the fund’s survival for retail, high net-worth, and institutional funds, respectively. At the same time, as alpha became more difficult to realize, the incremental survival probability associated with every 1% increase in performance has gone up to 5.24% for retail funds, 3.73% for high net-worth and 4.64% for institutionals.
The trends continued into this decade with even greater emphasis placed on performance: Every 1% increase in the average monthly return during the 2001-2005 period resulted in a 8.14%, 6.91% and.8.31% increase in survival probability for retail, high net-worth and institutional funds, respectively. The corresponding survival probability numbers for 1% decrease in standard deviations of monthly returns grew to 2.51%, 2.69%, and 2.72% for retail, high net-worth and institutional funds.