Turan Bali, Stephen Brown, and Mustafa Caglayan have a new paper out with an interesting result:

The two most important findings from this study are summarized as follows: (i) hedge funds with higher exposure to default risk premium in the past month generate higher returns in the following month; (ii) hedge funds with lower exposure to inflation in the past month generate higher returns in the following month.

The results are pretty significant. Here, “DEF beta” means exposure to default risk, while “INF beta” means exposure to inflation risk:

On average, between the period 1997 – 2008, hedge funds in the highest DEF beta quintile generate 5.6% more annual raw returns compared to funds in the lowest DEF beta quintile. Similarly, the average annual raw returns of funds in the lowest INF beta quintile are 4.7% higher than the average annual raw returns of funds in the highest INF beta quintile.

These results, interestingly, held both in the run-up to the crisis and during the crisis: they seem to hold in both booms and busts. But the paper doesn’t speculate much on the reasons for these results.

My feeling is that if you did a similar study on mutual funds, you’d get very similar results. Professional investors, in recent decades, have used nominal returns, not real returns, as their benchmark: if you’re comparing returns from year to year, you look at nominal returns, or nominal outperformance, rather than the inflation-adjusted figures. What’s more, hedge-fund and mutual-fund management and success fees are also based on nominal quantities.

What’s more, hedge funds in particular tend to be traders, who make short-term and medium-term bets on the performance of individual securities which rise and fall based on perceived default risk. A successful trader can make good money that way. Both inflation and inflation expectations are much harder to trade, and they act more as a hidden tax on hedge-fund profits than as an opportunity to make money.

All of which raises the question, of course: which funds (both hedge and mutual) have the highest exposure to inflation risk, and the lowest exposure to default risk? Those funds might be good ones to avoid.