Abstract
This paper investigates whether market conditions affect fund investor behaviour in the hedge fund industry, especially the volatility in the up and down markets. Using a sample of 5,254 individual hedge funds from January 1994 to December 2009, we find that hedge fund investors tend to invest less during up and down-volatile markets. They also adopt different investment strategies in these two market conditions. When market is calm and relatively predictable, there is almost no difference in their behaviors between up and down markets. We also find that smart money effect exists over both 3- and 12-month periods under all market conditions except volatile markets. A further investigation suggests that the observed smart money effect is largely driven by hedge fund performance persistence, which is present and significant is quiet markets only. The findings are relevant to portfolio theories concerning investor recognition of upside and downside volatilities.
Highlights
How investors allocate their assets to form portfolio according to risk, especially the risk in the up and down markets, is one of the topics under debate
Up-volatile markets are associated with significantly reduced flow sensitivities for both bottom and top performance groups, while all other markets are with increased sensitivities
Even though investors can be successful in picking good funds during volatile market periods, the significantly lower performance persistence across the hedge fund industry eliminates the “smart money” effect commonly observed in other market conditions
Summary
How investors allocate their assets to form portfolio according to risk, especially the risk in the up and down markets, is one of the topics under debate. Except volatile markets (both up-volatile and down-volatile), we find that smart money effect exists in all other market conditions over both 3- and 12-month investment horizons This indicates that when market is calm and relatively predictable, fund investors are capable of identifying good managers and can benefit from good performance at least for a short period of time. Given that the pattern of performance persistence is matched with that of “smart money” effect under various market conditions, the smart money effect in the hedge fund industry is largely driven by fund performance persistence in quiet markets It is not clear whether upside market volatility is as important as downside volatility in explaining investor behaviors, our overall results provide evidence that market conditions play a role in the investment process, that market volatility affects investors’ ability to pick winner funds and fund managers’ ability to deliver alpha, and that both upside and downside volatilities influence investment behaviors and hedge fund performance.
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