AUM growth as a signal of hedge fund quality - Is the investor herd right?

It is hard to determine whether one manager is better than another when looking at performance numbers. The sample sizes are often too small to distinguish return differences, so investors often looking for other signals that can be used to suggests one manager is better. One that is often used is growth of AUM. Call it the "wisdom of crowds" signal. If an investor cannot distinguish the return performance between two managers, he will place weight on the dollar opinion of others. If the herd is investing in manager X, perhaps they know something that others don't. The investor will free ride on the due diligence of others and invest with the manager who is growing faster. 

Unfortunately, this wisdom is a noisy signal. Growth may tell us something about past performance, but it may not be an indicator of future gains. It could be just dollar votes for past gains. There also is a strain of literature that past performance is not predictive of the future because the flow of funds will generate diseconomies of scale. There has been shown a link between past performance and the flow of funds, but we are asking a deeper question of whether fund flows tells us something about future performance that is not included in the past numbers. Additionally, is a growth strategy a tool by the management company to signal quality?

We believe that managers want to grow assets for a number of reasons beyond just the immediate gain of added revenue. Growth may signal quality, so managers will be willing to cut fees in order to grow and show the market there is strong demand for their services.  Discounts in price and the added cost of aggressive marketing may lead to a positive feedback loop that will generate more new revenue. Given this signaling effect, managers may be willing to suffer the risk of some diseconomies of scale and forgo maximizing income over the shorter run in order to generate the quality signal. 

This signaling is especially important if performance is within some tight range relative to other managers. 

• Growth at any cost is important for the small manager who wants to break-out from the pack of other small managers where the dispersion in returns is large. In this case, aggressive pricing and terms are used to gain the AUM signal even though costs for running the firm may not be fully covered. Spending on marketing is critical. 
• For the medium size manager, who may have already covered costs, high growth can accelerate investor interest even if performance is similar to other firms. Here, a strong marketing budget may eat into profit margins but generate longer-term business gains. 
• Large firms who have limited worries concerning fixed costs should continue to aggressively market products in an effort to popularize the firm for new alternatives and revenue. Given economies of scale, marketing is a inexpensive way of add revenue in a measured manner. Fee revenue may be more important than incentive optionality. Similarly, firms will work hard to maintain AUM to avoid the negative signals associated negative growth.

The link between asset growth and signaling may seem obvious for some marketing experts, but we believe this is especially critical when product quality via returns is harder to distinguish. To date, we do not believe that growth-pricing strategies with hedge funds have been fully explored as signals beyond performance.  

Is the herd right? This is a testable hypothesis. Do above average money flows signal better future performance after accounting for any past return effect?  Even a weak signal of quality is worth exploiting, if past performance is also a noisy signal and future relative returns are uncertain.