Unobserved Performance of Hedge Funds

Abstract

We investigate hedge fund firms’ unobserved performance (UP), measured as the risk-adjusted return difference between a firm’s reported gross return and portfolio return inferred from its disclosed long-equity holdings. Firms with high UP outperform those with low UP by 6.36% p.a. after accounting for typical hedge fund risk factors. UP better forecasts fund performance than other predictors. We find that UP is negatively associated with a firm’s trading costs and positively associated with intraquarter trading in equity positions, derivatives usage, short selling, and confidential holdings. UP exhibits significant persistence but investors do not seem to use it for manager selection.

Keywords: Hedge Fund Skill, Confidential Holdings, Derivative Usage, Short Selling, Unobserved Performance

JEL Classification: G11, G23