New research from the European School of Management & Technology (ESMT), in collaboration with the Rotterdam School of Management, has highlighted a worrying disconnect in the behaviour of investors in hedge funds and the subsequent performance of their investments, typically resulting in poor or volatile performance and exposure to unnecessary risk.
In a study of hedge fund performance according to investment style, covering 1,543 hedge funds over 10 years, ESMT’s research raises disturbing questions about the way that hedge fund investors invest and their willingness to actively chase performance at all costs, irrespective of the potential level of risk to which they are exposed. As a result, the authors of the research take the view that greater regulation is necessary to protect investors and that the provisions of the controversial Alternative Investment Fund Managers (Directive) ought to be welcomed.
The research reveals that investors systematically reward investment styles that have performed well over the previous three quarters, effectively substituting different investment styles for one another regardless of whether they are taking on higher levels of risk. This results in the top performing investment style attracting nearly $300 million more capital than the investment style that performs most poorly. A differential of 1 per cent in the performance of a given style attracts a further $9 million of investor funds. However, the volatility of hedge fund styles means that high performing investment styles often go on to underperform other investment styles in subsequent quarters.
The importance of ESMT’s research is that it is the first of its kind to show correlated investment behaviour based on style. Previous studies have not separated style-based investing from those investors rewarding the performance of individual funds or managers. ESMT calculates that approximately 13 per cent of total net asset growth can be attributed to “style-based investing”, and 20 per cent of the capital that is committed to the hedge fund sector.
The ramifications of style-based investment are significant, with the research suggesting that focusing on investment styles results in a potential inefficient allocation of capital across the hedge fund sector. The danger is that as increasing amounts of capital chase given styles (potentially attracting more managers into that style in turn), momentum investment starts to take hold, forcing up the price of overheated securities.
We have a two-fold issue here: whether investors’ naivety is leaving them overly exposed to risk they are not properly evaluating, and whether the growth of the hedge fund industry combined with that naivety means the sector poses a threat to financial stability,” says Guillermo Baquero, Assistant Professor at the European School of Management & Technology and an author of the report. “The fact that investors appear unable to recognise the risks of different styles and chase performance at all costs could leave them vulnerable and unprotected. This is exacerbated at the individual fund level by the opacity and lack of regulation of the sector, which already means that there are significant discrepancies in the level and quality of information reported.
“We should not be scared to tighten the regulatory screw on the hedge fund industry and force considerably greater disclosure. Now is the time to discuss deep, substantial and effective regulation that will genuinely be of use to investors and protect our financial system for the future.”
The fact that previously winning investment styles are subject to subsequent weak performance leads ESMT to conclude that a problem may lie within the simple movement of money itself. On a pure cash-flow weighted model, subsequent investor returns are more adversely affected than those recorded when style investment returns are equally weighted. In short, it is clear that the wall of cash being committed to a particular winning style only exacerbates later poor performance. This suggests that hedge fund strategies are not easily scalable and opportunities to profit rapidly diminish as more investor capital is committed.
“Given that the minimum investment thresholds for hedge fund investing have come down substantially in recent years, expanding the market and opening it up to retail investors, it is important to consider the level of risk hedge funds – and misinformed capital flows – may pose,” says Baquero. “We already know from the financial crisis that hedge funds were previously making increasingly directional bets in a rising market, which forced them into a situation of having to painfully unwind their positions. This in turn exerted huge downward pressure on already fragile markets. If naïve investment combines with an increasingly expanding industry, systemic risk may yet be posed in the future by the larger funds. We need financial reform that will anticipate the threats of the future, as well as deal with those of the past. Increasing regulation and investor communication around hedge funds will help considerably in making overall investment much smarter.”
ESMT’s research firstly reveals that there is no relationship between current and subsequent performance of a given investment style, and secondly calculates the impact on investor returns.
Looking at the two top performing and two worst performing investment styles in each quarter over the study’s 10-year time horizon reveals considerable volatility in the relative performance of different investment styles. For example, one of the most volatile investment strategies, Dedicated Short Bias, came first or second for 39% of the period surveyed. But this same strategy gave the worst or second worst returns for 55% of the time.