Friday, June 17, 2016

Hedge fund strategy distinctiveness matters

I love the old phrase from General George Patton, "If everyone's thinking the same, then someone isn't thinking." It can apply to hedge fund managers and skill. Those hedge fund managers that are willing to not act like others do better than their peers.  A study of hedge funds shows that if the return pattern of a hedge fund within its strategy style is more distinct, it will have better returns than their peers within a style bucket and this skill shows persistence. (See: The Road Less Traveled: Strategy Distinctiveness and Hedge Fund Performance, by Sun, Wang, and Zheng)

The authors tackle a simple question.  Do managers get paid to be different? Is distinctiveness associated with skill? They develop a Strategic Distinctiveness Index (SDI) which looks at the return difference relative to some peer measure. It is in the form of a distance function as measure by the lack of correlation to a group.

The peer group measure is the crux of the issue. If returns dispersion is caused by misclassification, then there really is not skill with distinctiveness. The authors look at peer classification as reported by a hedge fund service, cluster analysis, and factor analysis. They also adjust returns for potential manipulation. The results, as measure by the amount of distinctiveness versus managers who are least distinct and closest to the peer group, are all the same. There is value with distinctiveness and this value persists through time . Those who march to a different drummer do better. 

One could argue that if you are distinct and do poorly you will close up shop. A large survivorship bias may exist, but this work controls for that effect and gets the same answer. This managers that show distinctiveness, (greater active shares or hedging of their betas exposures) perform better. This distinctiveness is associated with smaller and younger managers who are more incentive fee based. Managers who get larger are less distinct. The newer managers have to make a splash and show their skill. Those managers with less skill hug their peers. 

If you think you have skill, express yourself. For investors, look for the iconoclast.

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