Hedge Fund Investors Don’t Care About Outperformance During Bloodbath

Investors may be patient with top-performing hedge funds, but they aren’t stupid. That’s the finding of a new study from the Federal Reserve Bank of Dallas, and its truth is being felt across the hedge fund industry, which suffered its largest outflow in seven years in July.

The report—which pretty much gives away is conclusion in the title, “Hedge Fund Investors More Rational than Rash”—says that, over the past decade, the trend is pretty much what you would expect: Investors pour their money into hedge funds that outperform their peers.

But should trouble strike—say, trouble in the subprime mortgage market—they are quick to flee.

“Capital flight tend to occur once the funds’ longer-term performance sinks in absolute terms, irrespective of relative performance,” the report said. In other words, investors aren’t buying what credit managers have been selling: Yes, we are down, but not as down as our peers.

“This pattern suggests that sustained deterioration in fund performance, or even strong signals pointing in that direction, will lead to capital outflows,” the report, released Tuesday, said. “We’ve seen this scenario play out recently for hedge funds entangled in mortgage losses.”

“Except in exceptionally adverse circumstance, we find hedge fund investors tend to focus on longer-term rather than immediate performance,” the study notes. “We must never forget, however, that especially adverse performance can lead to more abrupt capital outflows.”