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1 February 2014 CFA Institute Journal Review

Style Chasing by Hedge Fund Investors (Digest Summary)

  1. Robert H. Kaplan

Hedge fund investors allocate capital to better-performing and more popular hedge fund investment styles and away from less successful and less popular hedge fund investment styles, a behavior known as “style chasing.” The authors conclude that style chasing combined with selection of the best-performing funds within an investment style is a good capital allocation strategy.

What’s Inside?

The authors test hypotheses on changes in hedge fund total net assets under management (TNA) and hedge fund returns to determine whether style chasing is a significant consideration and/or beneficial to hedge fund investors. They also look for additional patterns of hedge fund investor behavior, including whether investors differentiate between funds operating within an investment style based on recent performance and whether increased capital flows into a style affect subsequent returns.

How Is This Research Useful to Practitioners?

The authors’ conclusions are generally consistent with the results of previous research on the effects of investment style, namely that “money follows money” in hedge fund capital allocation. The novel contributions of the authors relate to the combined effects of investment style, popularity, and performance on individual hedge fund popularity and performance in the capital allocation process. They arrive at several interesting conclusions.

Investment styles that perform better and are more popular in a given period are rewarded with higher capital inflows in subsequent periods. Although style popularity in a given quarter is predictive of style capital flows for the next three quarters, style performance persists for only one quarter. Increased asset flow to a successful style leads to an increase in the number of funds within that style.

The style effect is not equal for funds within the style: Better-performing and more popular funds within a style for a given period experience higher inflows in subsequent periods. There is also no evidence of persistent winning or losing investment styles in the fund returns. Style chasing alone does not generate profits; style chasing is only profitable when combined with the search for the best funds within a particular style.

The investment performance of an individual hedge fund that outperforms its style classification during the current quarter is relatively higher during the following two quarters compared with the return of a hedge fund that underperforms its style.

The conclusions of this research would be of interest to hedge fund managers, fund-of-funds managers, individual investors in hedge funds, investment consultants, risk managers, and academics studying hedge fund performance.

How Did the Authors Conduct This Research?

The authors review previously published academic research on the effects of style and performance on capital allocation among hedge funds and mutual funds and summarize the pertinent theories and conclusions to establish the current body of knowledge on the topic. They then use data in the Trading Advisor Selection System (TASS) database for the period of 1994–2003 for analysis. The TASS dataset is free of survivorship bias and contains self-reported monthly hedge fund TNA and returns (net of fees). The authors modify the original monthly data into quarterly data; eliminate closed-end funds, funds of funds, and funds with less than five quarters of data; and remove outlier data points for which TNA changes are outside the range of +300% and –90% within a period. The final dataset contains 33,064 fund-period observations for 2,274 funds grouped by the TASS hedge fund style classification system.

The authors propose four hypotheses for statistical examination using the modified TASS dataset, relate their interpretation of the results, and state conclusions with supporting tabular data in the appendices.

Hypothesis 1. The performance and flows of an investment style, relative to the performance and flows of other styles, positively affect the money flows of the style.

Hypothesis 2. The flows and performance of an individual hedge fund, relative to the flows and performance of its style, positively affect subsequent inflows into the fund.

Hypothesis 3. Investment style popularity positively affects the survivorship of individual funds within the style.

Hypothesis 4. A style chasing strategy in combination with intra-style fund selection is profitable for investors.

Abstractor’s Viewpoint

The authors’ research is thorough, reasonable, and generally consistent with previous research on the subject: Capital flows to better-performing and more popular investment styles and to better-performing funds based largely on recent investment performance. But their conclusion that increased capital flows to a fund do not adversely affect its returns is contrary to previous research cited by the authors. They also concede that varying the time period tested for performance persistence could produce results different from what they reported. Personally, I find it difficult to believe that returns do not diminish as competition and scale increase. Finally, although this paper was published in October 2013 and cites other research published as recently as 2011, the dataset used only covers the period of 1994 to 2003. Because the most recent datapoint in this study is approximately 10 years old, some conclusions may no longer be relevant.

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