It Pays To Invest in Unpopular Hedge Funds

Want to choose a hedge fund that will outperform? Stay away from the most in-demand strategies, according to a new study.

Academic researchers found that in the five years after hedge funds launch, the strategies that were unpopular when the funds were raised outperformed the hottest strategies by 3 percent annually on a risk-adjusted basis.  

This is because it’s harder to convince allocators to invest in strategies that they don’t see as attractive, according to researchers Charles Cao at Pennsylvania State University, Grant Farnsworth at Texas Christian University, and Hong Zhang at Tsinghua University’s PBC School of Finance.  

To make up for choosing strategies that are out of favor, unpopular hedge funds must demonstrate more skill — and better returns — before they can successfully lure investors, the trio argued.

The researchers used monthly hedge fund and return data from Lipper TASS, Hedge Fund Research, and Barclay Hedge to analyze a total of 31,402 live and defunct funds over the period between 1994 and 2016. 

To determine whether a strategy was popular, or hot versus cold, the researchers used two measures: the 36-month flows and the returns of a given strategy prior to the inception of a new fund. The group ranked 10 different strategies using these variables on a monthly basis. Any of the top three strategies in a given month were considered “hot,” while the bottom three were considered “cold.”

When seeking to explain why the unpopular strategies tended to outperform, the researchers found that the managers of these funds “exhibit significant skill in security-selection, but no skill in market-timing.” These managers aren’t loading up on alternative sources of risk like illiquidity or return smoothing either, the paper said. According to the study, the outperformance, which is persistent over time, can be attributed to “genuine managerial skills.” 

By contrast, managers using popular strategies demonstrated weaker skills in choosing securities and in market timing. In other words, new hedge funds targeting popular strategies “do not deliver alpha,” the researchers said. 

[II Deep Dive: Are These the Best Hedge Fund Strategies?]

The trio also looked at how new launches by existing hedge fund firms fit into these outcomes.

According to the paper, hedge fund firms with already-successful strategies are incentivized to launch new funds that are “clones” of their other funds. This reduces the cost of finding new investors and can help manage demand by funneling investors who are interested in other funds into new launches, the researchers argue. 

This doesn’t lead to better results, though. These funds, according to the paper, are “unlikely to contribute new skills and deliver superior performance.”