Abstract
Using a novel style identification procedure, we show that style-shifting is a dynamic strategy commonly used by hedge fund managers. Three quarters of hedge funds shifted their investment styles at least once over the period from January 1994 to December 2013. We perform empirical tests of two hypotheses for the motivations of hedge fund style-shifting, namely backward-looking and forward-looking hypotheses. We find no evidence that style-shifting funds are backward-looking. Instead, we show evidence that managers of style-shifting funds exhibit both style-timing ability and the skill of generating abnormal returns in new styles. The new styles that hedge funds shift to on average outperform their old styles by 0.76% and style-shifting funds on average outperform their new style benchmark by 1.10% over the subsequent 12-month horizon. Finally, we show that small funds, winner funds, and funds with net inflows are more likely to shift styles. This paper was accepted by David Simchi-Levi, finance.
Highlights
The hedge fund industry is known for innovation, speculation, high leverage, derivative usage, and dynamic trading (e.g. Cao, Liang, Lo, and Petrasek, 2017; Cao, Chen, Goetzmann, and Liang, 2018; among others)
Extending the performance attribution literature, in this paper we evaluate hedge fund managers’ skill by decomposing the performance of style-shifting funds into two components, namely the gain from fund managers’ style-timing ability or their ability to ride on style momentum, and the gain from fund managers’ expertise in the new styles
We identify hedge fund styles based on the highest correlation among those between fund returns and out-of-sample principal components (PCs) and identify style-shifting funds if a style change occurs between quarter t and quarter t-2
Summary
The hedge fund industry is known for innovation, speculation, high leverage, derivative usage, and dynamic trading (e.g. Cao, Liang, Lo, and Petrasek, 2017; Cao, Chen, Goetzmann, and Liang, 2018; among others). 2. Literature Review and Hypothesis Development It is well-known that hedge funds’ trading strategies are dynamic and that hedge fund managers may take advantage of their managerial discretion to shift investment styles (e.g., Fung and Hsieh, 1997, 2001, 2004; Brown and Goetzmann, 2003; Agarwal, Daniel, and Naik, 2009; Bollen and Whaley, 2009; Cai and Liang, 2012). They explain these low correlations as a reflection of some funds’ strategic deviation from peer funds within the same style and find that the deviating funds outperform their peers These studies suggest that hedge fund managers shift their investment styles because they are forward-looking and have the expertise to generate higher returns in the new styles. The forward-looking hypothesis, in contrast, suggests that shifting funds may actively seek additional investment opportunities given net fund inflows Both hypotheses suggest that funds are more likely shift styles during periods of high aggregate fund flows to the hedge fund industry
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