'Smart Money?': The Trading Performance of Hedge Funds in a Zero-Sum Contest

Abstract

This study makes an “apples-to-apples” comparison between hedge funds and all their counterparties, such as mutual funds’, in a zero-sum contest utilizing a new methodology. Extensive institutional transactions involving precisely matched trade portfolios shows that hedge funds are economically and statistically smarter traders gaining an internal rate of return of 8.36\% p.a. over the 11 years of our sample period at the expense of the equivalent negative return earned by their counterparties. The superior trading performance of hedge funds is reflected in their apparent bold contrarian trading strategy. It can be explained by their receipt of a daily private signal of fundamental value derived from the entire history of informed trades and prices, statistically rejecting the nested noisy partially revealing rational expectations equilibrium hypothesis.

Keywords: Hedge funds, Mutual funds, Calendar-time, Horizon-invariant, Trading performance

JEL Classification: G11, G12, G14