Capital Allocation to the Hedge Fund Industry. A Decomposition of Investors' Returns into Fund Selectivity and Style Timing


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Abstract

This study decomposes the allocation process of hedge fund investors between style allocation and fund selectivity. Using a sample of hedge funds between 1994 and 2000, we first estimate a model of money flows from a number of fund specific features and style-adjusted performance. From this model we obtain an estimate of expected money flows driven by fund selectivity while we link the aggregate residuals to the performance of style indices. Our contribution is twofold. On the one hand, we find evidence that investors chase the style. However we do not find evidence of style-timing abilities, nor   indications of momentum in style, which suggests that momentum investing is the result of a biased perception of style trends. On the other hand, our results do not support the smart-money effect in the fund-selectivity component. Overall, our study raises concerns that, despite growth, capital is inefficiently allocated across hedge funds.

 

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Peter Roosenboom

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