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Investor behavior: hedge fund returns and strategies

Andres Bello (School of Accountancy, University of Texas Rio Grande Valley, Edinburg, Texas, USA)
Jan Smolarski (Accounting and Business Law, University of Texas Pan American, Edinburg, Texas, USA)
Gökçe Soydemir (College of Business Administration, California State University, Turlock, California, USA)
Linda Acevedo (School of Accountancy, University of Texas Rio Grande Valley, Edinburg, Texas, USA)

Review of Behavioral Finance

ISSN: 1940-5979

Article publication date: 10 April 2017

1408

Abstract

Purpose

The purpose of this paper is to investigate to what extent hedge funds are subject to irrationality in their investment decisions. The authors advance the hypothesis that irrational behavior affects hedge fund returns despite their sophistication and active management style.

Design/methodology/approach

The irrational component may follow a pattern consistent with the observed hedge fund returns yet far distant from market fundamentals. The authors include factors beyond the original version of capital asset pricing model such as Fama and French and Carhart models, as well as less stringent models, such as APT and Fung and Hsieh, to test whether these models are able to capture the irrational nature of the residuals.

Findings

After finding that institutional irrational sentiments play a role in hedge fund returns, we note that the returns are not completely shielded against irrational trading; however, hedge fund returns appear to be affected only by the irrational component derived from institutional trading rather than that emanated from individuals.

Research limitations/implications

Different sources of irrationality may have asymmetric effects on hedge fund returns. Using a different set of sophisticated investors along with different market sentiment proxies may yield different results.

Practical implications

The authors argue that investors can use irrational beta to gauge the extent of institutional irrational sentiments prevailing in markets for the purpose of re-adjusting their portfolios and therefore use the betas as an early warning sign. It can also guide investors in avoiding funds and strategies that display greater irrational behavior.

Originality/value

The study advance the idea that the unexpected, hereafter irrational, component may follow a pattern consistent with the observed hedge fund returns, yet different from market fundamentals.

Keywords

Citation

Bello, A., Smolarski, J., Soydemir, G. and Acevedo, L. (2017), "Investor behavior: hedge fund returns and strategies", Review of Behavioral Finance, Vol. 9 No. 1, pp. 14-42. https://doi.org/10.1108/RBF-09-2015-0036

Publisher

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Emerald Publishing Limited

Copyright © 2017, Emerald Publishing Limited

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