Of pretentious hedge fund names and bad results: James Saft

(Reuters) - You probably already knew that hedge fund names are intended to impress, or even better to confuse just enough to make you stop asking questions, but most of all to inspire confidence.

You are, after all, as a hedge fund client, about to hand over a substantial sum to people whose probity and ability you cannot measure. Fund names must set the right tone, engender the right mood.

So we have the proliferation of funds with names intending to suggest ritzy addresses or locales, abstruse theorems and admirable but all-too-rare personal characteristics. “The Chappaquiddick Binomial Integrity Fund II” is one you can have for free if you are thinking of starting a hedge fund.

What we now know, thanks to a nifty new study, is that hedge fund names which sound dignified are sending a signal through all the noise of marketing, and it is not the one the marketing consultants intend.

Funds named with words which suggest gravitas, that solemnity and dignity the Romans thought essential to leadership, attract more investor flows and perform worse, according to the study. (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2939028)

“Hedge fund investors chase hedge fund names containing a special combination of words related to economics and geopolitics, or that convey power,” Juha Joenväärä of Finland’s University of Oulu and Cristian Ioan Tiu of the University at Buffalo write in the study.

“Having a name with gravitas is associated with abnormal negative performance.”

Using the Harvard IV psychological dictionary the study devises a weighting scheme to measure funds whose names suggest attributes and subjects including politics, economics, power and influence, a category they term gravitas, looking at a sample of almost 18,000 hedge funds from 1994 to 2013.

The funny part is, it works: every one word with gravitas increases the flow into an average fund by $227,120 a year.

The even funnier part, it backfires: funds with positive gravitas exposure in their names underperform those with negative gravitas by almost 1 percent of alpha, or outperformance, a year. Average annualized returns are 0.82 percentage point lower, volatility is higher and average maximum losses in a given period are higher.

These dignified funds are worse in almost all of the important ways you can measure, it seems.

A CONFIDENCE GAME

The study suggests that the so-called sophisticated investors who put money into gravitas hedge funds do learn, eventually reversing their flows of cash into them. They learn so well that the gravitas funds are more likely than other funds to ultimately fail, though perhaps what is being measured here is not investor learning but that managers without much talent are more likely to try to hide behind confidence-inspiring fund names.

The probability of going out of business of funds with the highest level of gravitas is more than 5 percent higher than those whose names have no gravitas.

Interestingly the gravitas funds have higher management fees and lower incentive fees. A management fee the manager gets to keep no matter what, while a performance fee only kicks in if pre-agreed hurdles are jumped. It is almost as if these guys know they are not that good.

Similar studies, with similar results, have been done about mutual funds, but mutual funds market to the great ignorant mass of investors, not the supposedly sophisticated hedge fund client base, most of whom are institutions.

Once again we are reminded of the extent to which financial services are a confidence game in which the ability to inspire belief is key to success, at least in terms of attracting clients.

It is also similar, in its ultimate message, to a paper from February which found that firms with more fund managers and analysts produced more volatility and were more likely to engage in benchmark-hugging closet indexing rather than truly active investing. That suggests that the extra employees were there to send a confidence-inspiring signal rather than to do actual and useful work. (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2896355)

The real message is the harder a firm tries to impress you, the more you should be wary of the value of its services. Sending a false signal of competence or gravitas is a good Darwinian tactic in an industry in which there is a huge gap in knowledge between practitioners and clients.

If you believe that long-term investment outperformance is a chimera then your investing should be done with institutions which do relatively easier things, like tracking an index cheaply, rather than more difficult ones requiring, well, gravitas.

Like certain great first-growth wines, more gravitas, or indeed investment skill, is bought than exists.

(James Saft is a Reuters columnist. The opinions expressed are his own)

(Editing by James Dalgleish)