Hedge Fund Performance, Market Regimes, and Drawdown Risk

How Market Regimes and Drawdowns Affect Hedge Fund Performance

Author

Nam Nguyen
October 18, 2026 • Estimated Reading Time: 4 minutes

Market dynamics are changing rapidly, and managing a hedge fund is becoming increasingly competitive and challenging. The same is true for investors seeking to allocate capital to hedge funds. In this edition, we explore whether investing in hedge funds is worthwhile and how to evaluate their performance, risks, and potential for generating future returns.

In this issue:

Latest Posts

  • The Role of Liquidity in Stock Returns and Option Pricing (8 min)

  • Correlation, Volatility-of-Volatility, and Sector Implied Volatility (10 min)

  • Reflexivity and the Dynamics of Option Markets (10 min)

  • The Effects of ETF Investing on Financial Markets (10 min)

  • Market Regimes and Changing Market Dynamics (10 min)

Do Hedge Funds Add Value?

Despite the growing popularity of passive investing, active hedge fund managers are still adding value to their investors’ portfolios. While passively managed funds can be a great option for some investors, active management can provide added benefits for those who are looking for better risk-adjusted returns and diversification, especially during market downturns.

Reference [1] showed that the correlation between market-neutral hedge funds and the stock market changes according to the market regimes. Specifically, the correlation is negative in bear markets and positive in bull markets.

Findings

  • The authors examine linear correlation and tail dependence between hedge funds and the S&P 500, conditional on financial market cycles.

  • The results show that market-neutral hedge funds exhibit negative correlations with the stock market during bear periods and positive correlations during bull periods, explaining their low overall correlation.

  • In contrast, other hedge fund styles maintain positive correlations with the stock market across both bull and bear periods.

  • Market-neutral and other hedge fund strategies exhibit tail dependence during bull markets but not during bear markets.

  • The findings suggest that market-neutral hedge fund managers can adjust their strategies according to financial cycles, providing evidence of market-regime timing ability.

  • The study demonstrates that ignoring changes in correlation and tail dependence across market regimes can lead to inaccurate risk management.

  • Further analysis using individual hedge fund data confirms the findings on dependence and market timing.

  • The research highlights the importance of incorporating financial market cycles into hedge fund analysis, portfolio management, and investment decisions.

In summary, the results from this study showed that investing in active funds is beneficial. Active hedge fund managers add value to the portfolio by executing market-neutral strategies. Hedge funds' performance was shown to be negatively correlated with the market during bear cycles. Thus, they could be great diversifiers to investors’ portfolios.

Reference

[1] Crego, Julio and Galvez, Julio, Cyclical Dependence in Market Neutral Hedge Funds, Banco de Espana Working Paper No. 2141, SSRN 3970564

Evaluating Fund Performance

A mutual fund’s performance depends on both the performance of the underlying securities in its portfolio and the portfolio manager’s skill. How can we identify a mutual fund that is likely to perform well in the future? Should we begin by examining its fees, investment objectives, and historical track record?

Reference [2] argues that maximum drawdown is an important metric for evaluating a fund’s future performance. Although the analysis focuses on mutual funds, the findings may also be applicable to actively managed hedge funds.

Findings

  • The authors examine the importance of maximum drawdown (MDD) in evaluating mutual fund performance, manager skill, and investor capital allocation.

  • The results show that maximum drawdowns are persistent and contain predictive information about future fund performance beyond conventional performance measures.

  • Among funds with relatively strong historical performance, those with lower maximum drawdowns outperform those with higher drawdowns by an average of 2.40% annually on a risk-adjusted basis (t-statistic = 2.87).

  • This performance advantage becomes more pronounced during periods of market turbulence, when fund manager skill is particularly valuable.

  • The study finds a significant negative relationship between maximum drawdowns and mutual fund flows, even after controlling for traditional performance measures.

  • Investors with greater risk aversion place more weight on maximum drawdowns when allocating capital, particularly during periods of heightened market risk aversion.

In summary, the findings suggest that maximum drawdown captures a distinct component of fund manager skill and provides valuable information for predicting future performance and investor behavior.

Funds with low maximum drawdowns will likely outperform their peers in the future. Another interesting finding is that fund flow is a decreasing function of maximum drawdowns, particularly among investors with greater risk aversion and during times of heightened risk aversion.

Reference

[2] Riley, Timothy Brandon, and Yan, Qing, Maximum Drawdown as Predictor of Mutual Fund Performance and Flows (2022). Financial Analysts Journal, SSRN 4150870

Closing Thoughts

Together, these studies highlight the importance of considering market regimes and drawdown risk when evaluating investment funds. The first demonstrates that correlations and tail dependence between hedge funds and the equity market vary across financial cycles, with market-neutral funds exhibiting evidence of regime-timing ability. The second shows that maximum drawdown contains predictive information about future fund performance and reflects an important component of manager skill.

Overall, the findings suggest that evaluating investment funds requires looking beyond historical returns and conventional performance measures to incorporate regime-dependent behavior, drawdown risk, and managers’ ability to adapt to changing market conditions.

Additional Reading

For further discussion on passive and active investing, refer to the previous issues:

Educational Video

Achieving Excellence: An Overview of Performance Valuation

This CFA Institute webinar provides an introduction to investment performance evaluation, focusing on how investors can assess portfolio returns, risk, and fund manager performance. It begins by distinguishing absolute returns from relative returns, emphasizing the importance of comparing portfolio performance against an appropriate benchmark or risk-free rate. Benchmarks should be investable, transparent, consistent with the portfolio’s investment objectives, and selected before the evaluation period to avoid selection bias. The presentation also explains how active managers seek to outperform benchmarks, while passive managers aim to replicate their performance. It then introduces risk-adjusted performance measures, including the Sharpe ratio, Treynor ratio, and information ratio, demonstrating how these metrics can help investors evaluate returns relative to different measures of risk.

The webinar subsequently examines performance attribution, which seeks to identify the sources of a portfolio’s returns and determine whether outperformance results from asset allocation or security selection. Using the Brinson-Hood-Beebower (BHB) attribution framework, the presenter illustrates how differences in portfolio weights and individual asset-class returns contribute to performance relative to a benchmark. A numerical example compares a portfolio allocated 60% to equities and 40% to bonds against a benchmark with equal allocations, demonstrating how allocation and selection decisions explain the portfolio’s excess return. Overall, the webinar provides a foundational framework for evaluating investment funds and understanding the sources of portfolio performance.

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