Predicting hedge fund performance when fund returns are skewed

Abstract

We show that fund-specific return skewness is associated with managerial skill and future hedge fund performance. Specifically, skewness in fund returns reflects managerial skill in avoiding large drawdowns. Using a new measure of investment skill that accounts for this managerial ability, we demonstrate that traditional performance measures under-estimate (over-estimate) managerial performance when returns exhibit positive (negative) fund-specific skewness. Our new measure is particularly valuable during periods of economic crisis, when the annual risk-adjusted out-performance is 5.5%.