Hedge fund skill - dependent on the environment

Hedge fund skills are dependent on the economic environment. There are more hedge fund managers who show skill during the expansion state of the economy over recession periods. If you want to hold the truly exceptional managers, you will look for those that do well in both expansion and recession periods.

The paper, “Measuring Hedge Fund Performance: A Markov Regime-Switching with False Discoveries Approach” by  Gulten Mero provides a different take on measuring hedge fund manager skill. The work uses some advanced econometrics to look at skill behavior in different states. The author looks at only one hedge fund style, equity long/short, but it does provide a good framework for thinking about skill in different environments. 

There are more alpha producers during the economic expansion. The skill producers decline by about 20% in a recession. Unskilled or no skill managers increase to over 50% during a recession. 

Recession will be associated with market declines and usually the market inflection point. Stock markets usually start to decline before recession and reverse near the end. Volatility will be higher during recession periods. Hence, it takes more skill to navigate these uncertain periods. As Warren Buffet has said, "You only find out who is swimming naked when the tide goes out."