What Hedge Funds Teach About Investment Management

Defining Diversity

Three professors recently asked a question: Do hedge funds that possess diverse management teams outperform those without? In "Diverse Hedge Funds," by Yan Lu, Narayan Naik, and Melvyn Teo, the authors found the answer to be an unqualified Yes. Initially, that result surprised me, but upon reflection it makes perfect sense, although not solely for the reasons provided by the paper.

Their inquiry does not address the common sense of “diversity”--that is, differences among gender, race, and/or religion. Ninety percent of hedge fund managers are male, an even higher percentage are white, and no database lists their religion. The authors therefore used alternate measures for evaluating the amount of diversity among management teams.

Those were: 1) educational background, 2) work experiences, and 3) nationalities. Specifically, management teams were deemed to be fully diverse if no portfolio managers attended the same university, had previously been employed by the same organization, or shared citizenship. Conversely, overlaps suggested a degree of uniformity--or, to use the authors’ term, homogeneity.

(No surprises among the data. The leading universities were Harvard, Penn, and Columbia; the most common former employers were Goldman Sachs, Morgan Stanley, and Merrill Lynch; and the top countries were the United States, Canada, and France. Thus, the prototypical hedge fund manager is an American who graduated from Harvard and later worked at Goldman Sachs. Sometimes, the stereotypes are entirely correct.)

Higher Returns

After running each team’s diversity score through a correlation calculation that included the risk-adjusted returns for several thousand hedge funds (both live and dead), each of which was headed by at least three managers, the authors found that funds run by managers with disparate educational backgrounds outgained those with similar backgrounds by 5.25 percentage points per year. Those with diverse work experiences also beat their homogeneous rivals by 5.25 points, while those with multiple nationalities outperformed single-nationality funds by an annualized 5.80 percentage points.

The numbers require a large caveat. Because hedge funds are not required to report their returns, instead volunteering their results should they so desire, hedge fund databases are notoriously unreliable. They are both incomplete and occasionally inaccurate. Also, it’s difficult to find information about hedge fund portfolios. Consequently, two funds that ostensibly follow similar strategies might in reality invest quite differently. That complicates the analysis.

But 5 percentage points per year is enough to overcome a multitude of data sins. What’s more, the authors performed a battery of performance-measurement tests. They also sorted funds by various noninvestment characteristics (for example, by fee structure), and used several methods of risk adjustment. No matter what their choices, the outcomes were similar. On average, funds with diverse management teams comfortably outclassed their conformist rivals.

Why So?

The authors posit that diverse management teams can "exploit a wider range of investment opportunities," because they have a broader set of experiences. The authors test that notion by assessing whether funds run by diverse teams are likelier to own securities that exploit 11 "market anomalies" that have been identified by academia, such as companies that have rapidly grown their assets, or that possess high stock price momentum. Indeed, those funds have.

The flip side of recognizing good situations is bypassing bad ones. If funds run by diverse teams hold more winners, perhaps they also are better at avoiding obvious mistakes. The professors find that to be the case. Diversely managed funds are less inclined to retain their losers (the disposition effect), overtrade, and pursue lottery-style stocks. (To capture those effects, they use hedge funds' quarterly 13-F filings, which list their long-only stock positions, albeit for the organization overall rather than individual funds.)

Diversely run funds also succeed at other aspects of hedge fund management. They suffer fewer steep drawdowns, report fewer operational violations, and enjoy longer shelf lives. They are also better at handling success. According to the authors, “fund-level capacity constraints are largely confined to hedge funds managed by homogeneous teams.” In contrast, funds managed by diverse teams tend to continue their relatively strong performances after receiving new assets.

Once again, the professors provide answers for these results. Greater diversity means lower investment risk, as the team instigates more “checks and balances.” Operations are tighter, since “members from different backgrounds are better able to restrain the fraudulent actions of specific individuals.” And fund capacity problems disappear because, thanks to their greater variety of experiences, diverse teams can invest more widely. They need not rely on only a few tactics.

Merit, Not Network

The authors’ claims are feasible. However, they could simplify their analysis. Each of their explanations can be placed under a single heading: meritocracy. Building a diverse team means hiring not by personal network--the randomly assigned Stanford roommate, or the friend from Credit Suisse--but instead by attempting to identify the person who is best suited to excel at the job. Taking such an approach professionalizes what until now has largely been a cottage industry.

Employing on merit naturally achieves the behavior that the authors identify. Selecting managers for their abilities, rather than because they are familiar parties, increases the likelihood that disconfirming observations will be acted upon. Yes, improving a team's diversity makes for greater collective experience, as the authors maintain, but it also stimulates action. It instills the mindset that what matters most when running the fund is not friendship, but results.

This precept, I think, can be extended. Although there isn't yet much conventional diversity among hedge funds, those companies that have brought aboard female and/or nonwhite managers may have benefited from that decision. (Such was the claim of this 2020 article, although based on limited data.) Also, as mutual fund and exchange-traded fund managers come from largely the same pool as hedge fund managers, this paper's lesson probably applies to registered funds, as well.

Organizational leaders sometimes talk about the importance of getting all employees “on the same page.” While sharing common values and goals is desirable, “Diverse Hedge Funds” suggests that much value also derives when co-workers read from different pages.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.