Academic journal article Indian Journal of Economics and Business

Does Investor Sentiment Play a Role in Hedge Fund Return?

Academic journal article Indian Journal of Economics and Business

Does Investor Sentiment Play a Role in Hedge Fund Return?

Article excerpt

Abstract

The current estimate of the hedge fund industry is over one trillion dollar and growth seems to continue with more than 8,000 funds. We study the existence of investor sentiment in the hedge fund industry using MorningStar database. We calculate fund flows as a measure of investor sentiment and analyze the fundamental characteristics of hedge funds that are favored by investor sentiment. We find an overwhelming evidence of investor sentiment in the hedge fund industry. We also find that investor sentiment is not governed by the fundamental characteristics of the hedge funds.

I. INTRODUCTION

Hedge funds have enjoyed healthy growth through the years and continue to increase in popularity, especially among high net-worth individuals. Recently, an increasing number of institutions have allocated a small portion of their assets to these alternative investments owing to their long-term success. The term "hedge fund" is used to describe a wide range of investment vehicles that can vary substantially in terms of size, strategy, and organizational structures. The strategies include selling stocks short on a bet they will fall and using borrowed money. Many of them hedge against declines in the market, but the techniques vary greatly.

One commonality surrounding hedge funds is the limited amount of information provided to potential investors. Typically information is limited to periodic (monthly, quarterly, or annual) returns. Even the leading hedge-fund databases provide incomplete information drawn from the fund-offering documents such as contractual provisions (fee structure, minimum investment size, and withdrawal provisions), descriptions of investments, styles of investment, and the periodic return.

The current estimate of the industry size is over one trillion dollar. The average hedge fund remains small, with less than $200 million in assets, compared with one billion dollar for the average mutual fund. In 2004, the average fund lagged behind the S&P index. Hedge fund performance was uneven in 2005. On an average hedge funds actually lost money in 4 out of 11 months.

In this paper we document the existence of investor sentiment in the hedge fund industry. We calculate fund flows as a measure of investor sentiment and analyze the fundamental characteristics of hedge funds that are favored by investor sentiment. The paper proceeds as follows: Section I gives a brief history of the hedge fund industry. Section II provides a review of the literature. Data, modeling, and results are outlined in Section III. Section IV summarizes our findings and contributions.

II. A BRIEF HISTORY OF THE HEDGE FUND INDUSTRY

In 1949, A.W. Jones introduced the concept of a hedge fund by combining a leveraged long stock position with a portfolio of short stocks in an investment fund with an incentive fee structure. From this simple concept, hedge fund investment practices and strategies continue to evolve. Consequentially, many hedge fund characteristics have changed significantly, but many of the fundamental features have remained the same. Moreover, hedge funds are no longer unique to the U.S. markets, but have become a fixture in the global marketplace. In the United States, the funds normally offer their shares in private placements and are limited to 100 or fewer high net-worth investors in order to make use of regulatory exemptions provided under the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Company Act of 1940.

Interest in hedge funds and their performance has waxed and waned over time, but recent publicity has lead to hedge funds enjoying healthy growth. For instance, the high net-worth investors created through the bull market of the late 1980s started to invest in hedge funds as a means of enhancing their returns. In 1990, there were about 600 hedge funds worldwide with assets of approximately $38 billion. …

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