Steer Away from New Hedge Funds in Times of High Demand

Stockholm (HedgeNordic) – Committing capital to a new hedge fund launched in times of high investor demand for hedge fund management is not a good idea, concludes a new research study conducted by three professors from two U.S. universities. The study finds that funds opened during hot markets characterized by high investor demand for hedge funds significantly underperform peer funds already existing in the market, have lower survival rates and exhibit higher operational risk.

Florida State University professor Lin Sun and finance professors Zheng Sun and Lu Zheng from the University of California at Irvine examined the strategic timing behavior of hedge fund companies in a paper titled “Strategic Timing of Hedge Fund Starts.” The findings are based on data retrieved from the Thomson Reuters Lipper Hedge Fund Database, with the study conducted on a sample of 8,630 unique funds operating between January 1994 and December 2014.

Using three different proxies for investor demand for hedge fund management, the researchers observe more hedge fund launches in hot markets than in cold markets characterized by muted hedge fund investor sentiment. There are 25 hedge fund inceptions per month on average in cold markets and 45 inceptions in hot markets when using one of the three proxies to define investor demand. The differences are even larger when using the two other proxies, with 26 and 27 more launches per month in hot markets than in cold markets, correspondingly.

More importantly, the study concludes that hedge funds opened during hot markets underperformed the vehicles already existing in the market by 29 basis points to 48 basis points per month, corresponding to a difference of 3.5 percent to 5.8 percent in annualized returns over a fund’s lifetime. In addition, funds opened in hot markets have a shorter life span and exhibit significantly lower survival rates than the funds opened in cold markets in the first two to three years after inception. This implies hedge fund companies tend to open low-quality funds during hot markets.

Beyond delivering underperformance, hedge funds opened in hot markets also exhibit higher operational risk, which reflects a wide range of variables such as fees, reporting practices, auditing practices, personal capital invested, among other things. In conclusion, the researchers find that “funds opened in hot markets with high sentiment experience poor future performance, survive shorter lives, and exhibit greater operational risk.” “The timing behavior of hedge fund companies is not in the best interest of investors,” the researchers add.

Picture: (c) Ollyy—shutterstock.com