EUROPE - The EU's Alternative Investment Fund Managers (AIFM) Directive should be welcomed as a way to protect investors from exposing themselves to unnecessary risks in the pursuit of higher hedge fund returns, according to an academic study.
The European School of Management & Technology (ESMT) together with the Rotterdam School of Management has produced evidence that investors systematically allocate money to hedge fund investment styles that have performed well over the previous three quarters without regard for any change in the level of risk.
The study showed the top performing investment style over the preceding nine months saw $300m (€247m) more in capital inflows than those that performed less well, despite there being well established volatility in the asset class. The report's authors concluded that investors were effectively substituting different investment styles for another regardless of whether they were taking on more risk.
ESMT said its research was the first to show correlated investment behaviour based on hedge fund investment styles, with previous studies not separating style-based investing from those investors rewarding the performance of individual funds or managers.
Guillermo Baquero, assistant professor at the ESMT, said: "The fact that investors appear unable to recognise the risks of different styles and chase performance at all costs could leave them vulnerable and unprotected.
"This is exacerbated at the individual fund level by the opacity and lack of regulation of the sector, which already means that there are significant discrepancies in the level and quality of information reported."
Baquero argued that the findings "raise serious concerns about investors' ability to make the right allocation choices and suggest that increasing investor protection and curbing unnecessary risks and speculative activity of hedge funds should be a priority for regulators".
The study of the performance of 1,543 hedge funds over a 10-year period showed there was no relationship between current and subsequent performance of a given investment style. For example, the dedicated short bias strategy came first or second in the list of top performing styles for 39% of the period surveyed, but the same strategy also gave the worst or second worst returns for 55% of the time.
Despite this the research suggested that investors were "highly likely" to reward very extreme movements in style. It showed that if a particular style moved from being bottom to top performer within a quarter it was rewarded with 6% of investor inflows, and 12% of capital over the following three quarters. Yet the study demonstrated that over several quarters the previously low performing strategies increasingly outperformed the earlier winners.
Baquero said: "Naturally investors will be drawn to investments that demonstrate more favourable returns, yet our research acts as a cautionary tale about falling into the age old trap of trusting to past performance."
Therefore he described the proposed AIFM Directive as a "milestone", and claimed the industry should "not be scared to tighten the regulatory screw on the hedge fund industry and force considerably greater disclosure".
Baquero added: "Whilst no-one would wish to reduce hedge funds to a mere offshoot of the mutual fund sector, the industry needs to take responsibility for its increasing size, role and attraction for much more mainstream investors."