Style Investing: Evidence from Hedge Fund Investors

Abstract

This study tests the hypothesis that one component of investors' allocations across hedge funds takes place at the style level as a result of extrapolative expectations. Using a sample of 1543 hedge funds between 1994 and 2004, we decompose the allocation process of hedge fund investors between style allocation and fund selectivity. Our contribution is twofold. First, we find evidence that the aggregate of investors actively shift their allocations across style categories by chasing the winning styles in the previous one to three quarters. These results suggest that investors perceive styles as substitutes to each other, irrespective of the risk-return properties of each style category. Second, we do not find evidence of style-timing abilities of hedge fund investors, nor indications of momentum in style index performance at quarterly horizons. This suggests that the chasing-the-winner strategy among styles reflects correlated sentiment of investors, consistent with the style-investment hypothesis. Overall, our study raises concerns that, despite growth, capital is inefficiently allocated across hedge funds.