Hedge fund managers often regard themselves as the masters of the fund management universe.
So how do these financial wizards shape up? Results are now in for last year's hedge fund managers' performance from the Chicago-based Hedge Fund Research. They show that overall returns from hedge funds were a modest 6.2 per cent, compared with the 11.4 median return reflected in the FTSE All World equity and the Barclays Global Aggregate bond indices, as reported in the Financial Times.
Over the past five years hedge fund managers failed to reach the industry's normal target of returns of 3 per cent to 4 per cent above Libor, reported the FT with reference to Hedge Fund Research data.
There are many explanations for this lacklustre performance but one of the more compelling comes from research by the Edinburgh and Warwick business school academics Arman Eshraghi and Richard Taffler*. They surveyed actively managed US equity funds in the period 2003-09 and found that, "excessive overconfidence is associated, to a large extent, with diminished future investment returns in the 12 months following publication of the annual report. This effect is robust across different investment styles, although it appears to be stronger among growth-oriented funds. A closer investigation reveals an inverted-U relationship between fund manager overconfidence and subsequent investment performance."
What the academics are saying is these fund managers got far too cocky about their abilities following a run of success, which led them to make poor subsequent investment decisions.
Eshraghi and Taffler developed three proxies for measuring overconfidence. This involved using diction software to find language in the fund manager's reports for identifying optimism, excessive certainty and self-reference. The concept of optimism is generally understood as being "language endorsing some person, group, concept or event or highlighting their positive entailments".
The researchers looked for high use of words known as self-reference, namely expressions such as I, me, mine, us and ours.