The best time to commit to a new hedge fund may be when the industry is out of favor, according to new research from a trio of business school professors.
Although fund launches tend to spike when investor demand for hedge funds is high, funds opened during these “hot” markets deliver relatively poor performance and exhibit higher operational risk, found Florida State University professor Lin Sun and finance professors Zheng Sun and Lu Zheng of the University of California, Irvine.
These funds furthermore have “significantly lower” survival rates during the first three years after launching, the authors said.
“It is natural to ask whether hedge fund companies take advantage of investor sentiment and lax screening,” they wrote.
Their findings, based on data from the Thomson Reuters Lipper Hedge Fund Database, suggest this might be the case. Analysis of 8,630 hedge funds operating between January 1994 and December 2014 showed that hedge fund managers launched nearly twice as many funds in hot markets compared to “cold” markets when investor sentiment is muted.
[II Deep Dive: Investors Pull Back From Hedge Funds]
According to the study, hedge funds opened during hot markets underperformed hedge funds already in the market by 29 basis points to 48 basis points per month, adding up to a difference of 3.5 percent to 5.8 percent in annualized returns over a fund’s lifetime. They were also more likely to shutter within the first two to three years after inception.
The findings were consistent even after the authors accounted for the financial crisis by eliminating hedge funds launched between 2006 and 2009.
Beyond having lower returns, these hedge funds also exhibited higher operational risk, which the authors estimated using variables such as fees, reporting practices, and how much personal capital hedge fund managers have invested.
“Fund companies open more funds in hot markets, and these funds exhibit inferior performance, shorter survival, and greater operational risk than funds opened in cold markets,” the authors concluded. “The timing behavior of hedge fund companies is not in the best interest of investors.”