Are hedge fund investors really as smart as they are presumed to be?

Whether active management can produce positive abnormal returns and if active managers can persistently beat the market, has been widely discussed due to the sheer size of the mutual fund and hedge fund industry as well as the question whether active investment management can justify its accompanying higher fee structure in comparison to passive index investments. Furthermore, in a semi-strong efficient market, active management should not be able to produce superior excess returns persistently (Bollen and Busse, 2005), resulting in the adequacy of the mutual fund performance literature in answering important questions on market efficiency. A heavily cited paper investigating this issue is a work by Jensen (1969) that examines the ability of portfolio managers to outperform the market. This seminal work led to a rather large research area within the field of finance. While most of the literature in mutual and hedge funds is focused on performance persistence, another vital insight that can be gained from mutual and hedge funds data is how investors take their investment decision. Sirri and Tufano (1998) find that equity mutual fund investors base their investment decision on past performance. More importantly they find that investors do so asymmetrically by investing disproportionally more in funds that performed very well but at the same time are not very sensitive to bad performance when deciding to divest. Fung et al. (2008) find that hedge fund investors exhibit a much higher flow performance sensitivity compared to mutual fund investors and are more likely to divest when a fund exhibits bad performance. This result suggests that mutual fund investors take different investment decisions to hedge fund investors. Current legislation on the hedge fund industry does take this difference in behavior into account by implicitly assuming that hedge funds investors are more knowledgeable than mutual fund investors. One might also expect that institutional mutual fund investors are more knowledgeable than the average retail investor and their behavior should therefore be fairly similar to the fund purchasing behavior of hedge fund investors. A paper by Evans and Fahlenbach (2012) studies the difference in performance of retail only and institutional as well as twin funds by considering fund flows of institutional fund investors as a way of exercising market governance. Unfortunately, they only look at mutual funds and do not consider hedge funds within their study. A setting similar to the one by Evans and Fahlenbach (2012), while measuring performance via a value-added approach designed by Berk et al. (2014) should enhance our understanding of the fund purchasing decisions by hedge fund investors in comparison to professional institutional investors and, thus, provide some more clarity on the adequacy of the current implicit assumption in legislation that hedge fund investors are more knowledgeable than the average retail mutual fund investor.