Study says return-chasing could be “driving a wedge between fund and investor returns”
| Mar 12th, 2009 | Filed under: Academic Research, Performance, Analytics & Metrics, Today's Post | By: Alpha Male |
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When conducting due diligence on a hedge fund, it’s appropriate to ask a manager for their AUM history along with their return history. After all, studies (and intuition) say that assets start to flow into a fund only after it has put some solid numbers. Naturally, young hedge funds have fewer assets than more mature ones.
But studies show that emerging managers also produce out-sized returns. Skeptics of hedge fund indexes suggest that young funds only report their results publicly if they have achieved positive early results – leading to a “back-fill bias”. Others say that its simply easier to produce good returns with less assets under management. But whatever the reason, it seems that the golden years for many hedge funds happen early in life.
This is a useful observation for funds of funds and other hedge fund investors who are trying to tilt the playing field in their favour. But it also has a profound implication on the returns actually experienced for the average hedge fund investor. Essentially, those who invest in a fund after a hot start in life experience a much lower overall return than those lucky enough to have gotten in the ground floor.
Studies have long shown that the propensity to jump horses in mid-race leads to lower returns for equity investors than for the market as a whole. Now a study on hedge funds shows that this axiom also applies to hedge fund investors. More…
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The clients are going to do it, regardless of their apparent levels of sophistication or expertise. Studying investor behavior has shown me time and again that extrapolation is the greatest error for most people, professionals and amateurs alike. We’ve just witnessed one of the biggest examples of it (done to the sound of http://researchpuzzle.com/blog/2009/03/05/one-hand-clapping/).
It is the responsibility of the manager to step outside of the excitement of the day, realize the human tendency to pile in, and consider whether the expectations of the investor are likely to be met. That doesn’t mean you don’t accept money when times are good, but it may mean that you don’t accept some of it, and that you do everything possible to make sure that the prospect has realistic expectations going in. It’s actually better for everyone concerned in the long run.