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The Economics Behind Successful Hedge Funds

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

Grant FarnsworthThe 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 circumstances 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 circumstances 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 Initiative here.

Photo: Grant Farnsworth

Grant Farnsworth

Assistant Professor of Professional Practice
Finance Department

Neeley 3133