Upside potential of hedge funds as a predictor of future performance

Abstract

This paper investigates the relationship between upside potential and future hedge fund returns. We measure upside potential based on the maximum monthly returns of hedge funds (MAX) over a fixed time interval, and show that MAX successfully predicts cross-sectional differences in future fund returns. Hedge funds with strong upside potential generate 0.70% per month higher average returns than funds with weak upside potential. After controlling for alternative risk and performance measures, funds’ market-timing ability, and a large set of fund characteristics, the positive link between MAX and future returns remains highly significant. We conclude that MAX, as a simple proxy for realized noln-normalities in hedge funds, offers incremental information on future hedge fund returns above and beyond provided by standard risk, performance, and market-timing measures.