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Why Unconventional Hedge Funds May Not Outperform, After All

Hedge funds with the most differentiated strategies deliver inferior performance after taking risk and higher fees into account, a new study found.

  • Amy Whyte

Hedge fund managers who differ from the crowd perform worse than peers despite the common belief that unconventional investment strategies produce better results, according to new research from the University of Kent.

While previous studies have found that hedge funds with unique strategies tend to beat their industry-conforming peers, the outperformance disappears when risk and fees are taken into account, University of Kent researchers Ekaterini Panopoulou and Nikolaos Voukelatos found in a paper published last month.

The unique investment ideas tend to involve bigger fees and “substantially” higher risk without offering “sufficiently higher returns,” they said in the paper. While some skilled managers succeeded in producing superior risk-adjusted returns, the researchers found that deviating from peers’ strategies generally led to a deterioration in performance.

“It might well be the case that more skilled managers seek to achieve elevated performance in ways that are distinctive from the ideas implemented by their peers,” wrote Panopoulou and Voukelatos. “These distinctive strategies seem to come at a significant cost to investors, both in terms of risk exposure and higher fees.”

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The study was based on an analysis of more than 9,500 hedge funds tracked by the BarclayHedge database between January 1994 and August 2015. The researchers divided them into 12 investment-style categories, such as long-short, event-driven and relative value, and compared the performance of hedge funds within each style.

To determine which ones had the most unique strategies, Panopoulou and Voukelatos identified those funds whose performance deviated the most from the average return of their style group.

The most-conforming funds produced an average return of 0.75 percent a month when portfolios were rebalanced monthly, while the least-conforming saw a 1.19 percent gain, according to the paper. But these higher returns came with increasing levels of downside risk, to the extent that unique hedge fund strategies delivered “inferior” performance when the researchers assumed a “reasonable level” of risk aversion.

“Funds with the most distinctive strategies offer the worst performance,” they said in the paper. “At the other end of the spectrum, funds that deviate the least from the consensus of their cohort are found to offer the highest risk-adjusted returns.”