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A Warm Embrace or Cold Shoulder for Hot Hands?

| | Posted in: Individual Investing, Mutual/Hedge Funds

Do sophisticated (wealthy) investors chase hedge fund returns? If so, should they? In their March 2006 paper entitled “Do Sophisticated Investors Believe in the Law of Small Numbers?”, Guillermo Baquero and Marno Verbeek investigate whether sophisticated hedge fund investors exhibit “hot hands” bias by overreacting to small samples of fund performance. They hypothesize that investors who believe that hedge fund performance is predominantly skill (luck) are prone to overestimate the likelihood of performance persistence (mean reversion) in small samples, leading to an overly trend-following (contrarian) investing style. Using quarterly performance and funds flow data for 752 hedge funds between 1994 and 2000, they conclude that:

  • There is some degree of management skill in hedge fund performance. The longer a winning or losing streak, the higher the probability that the streak will persist. In other words, there are hot hands and cold hands.
  • The longer a winning (losing) streak, the more likely a fund will have positive (negative) money flow, indicating that the average hedge fund investor follows a trend-following or momentum strategy.
  • Streaks are not the only predictor of future fund performance. Fund size, age, management fees, incentive fees, managerial ownership and investing style also help predict performance.
  • The impact of past performance on flows exceeds that justified by a more robust consideration of other predictive factors, suggesting that investors overestimate the role of management skill in generating returns.

In summary, even sophisticated hedge fund investors could improve their returns by relying more on homework and less on gurudom.

Does the period 1994-2000 used in this study offers enough variety in equity market environments to support definitive conclusions about performance persistence and therefore the relative importance of skill and luck?

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