TCU Assistant Professor of Finance Grant Farnsworth researched how a hedge fund’s inception impacts its overall performance and success.
June 15, 2021
By Neeley Analytics Initiative
The use of hedge funds as an investing instrument for financial portfolios has seen a dramatic rise in the past decade, given their extensive use of complex investment strategies. However, what makes a hedge fund successful? Grant Farnsworth, assistant professor of finance at the TCU Neeley School of Business, has an answer that pertains to the inception of the hedge fund itself.
Farnsworth, along with his co-authors Charles Cao at Pennsylvania State University and Hong Zhang at Tsinghua University in Beijing, China, conducted a study to understand how the circ*mstances around the inception of a hedge fund (i.e., its affiliation, the prior reputation of its manager and the popularity of the strategy it employs) may be related to its performance.
Farnsworth’s contribution in the research, “The Economics of Hedge Fund Startups: Theory and Empirical Evidence” was recently published in the Journal of Finance.
As a quantitative researcher who previously worked in the hedge fund industry, Farnsworth has been studying hedge funds for quite some time. Over the years, he noticed that the average lifespan of a hedge fund is quite short – less than five years. Sometimes these ideas get funded and sometimes they don’t.
As such, the success (or failure) of a fund is not easy to discern. Is it because of the quality of the idea? Its popularity? Or perhaps, the ability of the manager to persuade investors to join the fund?
“I was interested in how the circ*mstances around the inception of the fund are related to the actual quality of the fund and its ability to perform well after getting funded,” Farnsworth said.
In this research, Farnsworth found that hedge funds that start on their own, without the aid of a fund family, tend to perform better. In addition, funds that start up in hedge fund strategies that are not popular with investors at the time of their inception (they face a headwind) outperform even more. On the other hand, funds that start up within a family or in a strategy that is popular among investors tend to underperform and tend to be clones of existing funds within the same family.
“There is only so much unique skill among hedge fund managers and the difficulty of starting a fund on your own tends to leave only the strong standing,” Farnsworth said.
These research findings have important implications for hedge fund managers. A major portion of a hedge fund manager’s job is raising capital. To some degree, marketing, reputation and affiliation can substitute for investing skill. The best funds, from the perspective of an investor, are those that may not be easy to find in the market, or which appear to represent more of a risk because their managers are not experienced or affiliated with an existing fund.
“It seems that a contrarian strategy – investing in strategies that other hedge fund investors are shunning at the moment – is a good idea,” Farnsworth explained. “Of course, investors also face a trade-off because doing due diligence on a large number of funds is costly and time consuming. Moreover, they may face constraints on what type of funds they can invest in.”
Read the full study in the Journal of Finance here.
Learn more about the Neeley Analytics Initiativehere.
FAQs
Hedge funds use unique trading strategies for investing in order to beat the returns of the market. They take on higher risk, hedge their risk, invest in alternative assets, and use active management when investing. They are typically only open to institutional investors and high-net-worth individuals.
Are hedge funds good for the economy? ›
“Hedge funds can pose a risk to financial stability when they use excessive leverage, adopt highly speculative strategies, or have a strong correlation with other market participants.
Do hedge funds actually beat the market? ›
To non-professionals, beat the market can mean instead deliver a higher return than the S&P500. Most hedge funds try to deliver alpha rather than beat the market in the second sense. They tend to be run at much lower volatility than the S&P500, 4% to 6% annual volatility rather than 15% to 20%.
Why do rich people use hedge funds? ›
Hedge funds were developed, in part, to help investors manage investment risk. Their market-neutral, or balanced, approach to investing helps seek out positive returns by investing in varied instruments over long- and short-term periods.
Why are hedge funds so lucrative? ›
One possibility is the nature of the hedge fund industry – very little regulation, huge pools of equity capital, strategic flexibility, and tremendous liquidity – allows funds to move more quickly to capture value than its primary competitors: the massive, highly regulated, and somewhat stodgy mutual fund industry, or ...
How do hedge fund people make so much money? ›
Key Takeaways
Hedge funds make money as part of a fee structure paid by fund investors based on assets under management (AUM). Funds typically receive a flat fee plus a percentage of positive returns that exceed some benchmark or hurdle rate.
How much do hedge funds outperform the market? ›
The average annual return for hedge funds was about 4.956%, while the S&P 500 averaged 14.4%.
What are the cons of hedge funds? ›
A fund of hedge funds may have extra risks. For example, it may invest in multiple hedge funds, across assets and markets. This can make it harder to know where the fund invests your money, and what the risks are. You may also have to pay more fees.
Do hedge funds do well in a recession? ›
Hedge funds are designed to make money regardless of market conditions. Investing in a foul weather fund is another idea, as these funds are specifically designed to make money when the markets are in decline.
Does S&P 500 outperform hedge funds? ›
Not only did the average multistrategy return trail far behind the tech stock-powered 24% gain of the S&P 500 in 2023—the 4.9% multistrat average trailed the typical hedge fund and even the 5% return that one could recently get risk-free from a Treasury bill.
Citadel has now made $74 billion for investors since its inception in 1990, more than any other hedge fund firm.
Why do most hedge funds fail? ›
Some strategies, such as managed futures and short-only funds, typically have higher probabilities of failure given the risky nature of their business operations. High leverage is another factor that can lead to hedge fund failure when the market moves in an unfavorable direction.
Will hedge funds exist in 10 years? ›
Overall, the consensus is that hedge funds will continue to grow but will adapt to lower fees, greater use of technology, and increased access to retail investors.
What is the ROI of a hedge fund? ›
What rate of return do most hedge funds give initial investors? Most hedge and private equity funds target a net IRR of 15% for their investors (after fees). This provides their investors with a meaningful premium over historical average stock market returns of 8%.
What type of people invest in hedge funds? ›
Therefore, an investor in a hedge fund is commonly regarded as an accredited investor. This means that they meet a required minimum level of income or assets. Typical investors are institutional investors, such as pension funds and insurance companies, and wealthy individuals.
How do hedge funds get such high returns? ›
Relative value hedge funds seek to profit from price differentials in related securities, such as stocks, bonds and derivatives. To do this, fund managers must predict changes in stock prices or rates, capturing excess returns, according to Oxford Academics.
What percentage of hedge funds succeed? ›
Goldman, which has helped launch and finance thousands of hedge funds, said almost all newcomers survive their first year but that only 62% of all funds remain in business after five years.
What is special about hedge funds? ›
Hedge funds can provide your portfolio with alternative sources of return and different risk exposures by accessing asset classes in unconventional ways, such as shorting, and greater use of derivatives and leverage. Some hedge fund strategies are designed to capture positive returns in all market environments.
Why are hedge funds so secretive? ›
Protecting Investors
Hedge funds offer their securities as private placements, on an individual basis, rather than through public advertising, and need not register as securities issuers or publicly disclose their financial performance and asset positions.
The use of hedge funds as an investing instrument for financial portfolios has seen a dramatic rise in the past decade, given their extensive use of complex investment strategies. However, what makes a hedge fund successful? Grant Farnsworth, assistant professor of finance at the TCU Neeley School of Business, has an answer that pertains to the inception of the hedge fund itself.