Hedge fund managers who drive Ferraris or other sports cars are likely to take greater investment risks than those who drive the humble minivan, new research from Monash Business School shows.
But the “fast and the furious” approach isn’t so good for investors, with returns from these managers showing greater volatility and disappointing results.
In the first empirical study analysing the implications of personal lifestyle choices on investment behaviour, Monash Business School’s Professor Stephen Brown and colleagues show that sports car owners’ preference for sensation-seeking also infiltrates their work.
Professor Brown, also an emeritus David S. Loeb Professor of Finance at New York University Stern School of Business, co-wrote the paper Sensation-Seeking, Sports Cars, and Hedge Funds with Yan Lu, from the University of Central Florida, Sugata Ray, from the University of Florida and Melvyn Teo from Singapore Management University.
The hedge fund industry naturally attracts “sensation-seekers”, typically using complex and unconstrained strategies through short selling, leverage and derivatives.
The paper finds that hedge fund managers who drive sports cars prefer to invest in lottery-like stocks with high past daily returns. They are also more likely to use unconventional strategies and actively trade, compared to other managers.
“Motivated by sensation-seeking, fund managers often take substantial financial and operational risks for non-pecuniary reasons unrelated to performance,” writes Professor Brown.
The study uses the purchase of performance cars as a proxy for sensation-seeking and compared it to the performance of managers that bought a practical but unexciting minivan.
To carry out the study, the research team hand-collected US vehicle purchase records and details from 2006 to 2012. They then categorised these into sports cars, minivans, and other cars.
The data was evaluated against monthly net-of-fee returns and assets-under-management data of both live and dead hedge funds. The team matched 1774 vehicles to 1144 of US-based hedge fund managers, of which 163 were sports cars and 101 were minivans.
The empirical results are striking.
Professor Stephen Brown
“We find that hedge fund managers who purchase performance cars take on more investment risk than do fund managers who eschew performance cars.
“Specifically, sports car drivers deliver returns that are 1.8 percentage points per annum more volatile than do non-sports car drivers. This represents a 16.6 per cent increase in volatility over that of drivers who shun sports cars.”
In comparison, mini-van owner generate returns 1.28 percentage points per annum less volatile than do other owners – an 11.7 per cent reduction in risk compared to other managers.
The findings show that such risk-taking isn’t great news for investors, with sports car-owning managers failing to generate greater returns than other managers.
The paper found the Sharpe ratio, which are used by institutional investors to assess the risk-adjusted performance of managers, was markedly lower in sports car owners than those with other cars.
The Sharpe ratio characterises how well the return of an asset compensates the investor for the risk taken. The higher the ratio, the better return for the risk taken. But Prof Brown and his colleagues found these managers had an annualised ratio that was .34 lower (or 40 per cent) than other car owners.
The study also found sports car owners are also more likely to terminate their funds and be subject to regulatory actions as well as civil and criminal violations. They tend to turn over their stock portfolio more often and prefer non-index stocks and use more distinct strategies. This portfolio turnover results in reduced returns.
Also, these managers gravitate toward securities that provide intense experiences such as lottery-like stocks.
“The research shows that these managers who buy performance cars tend to be over-confident,” Professor Brown says.
The study was presented at the recent Monash-Q Group Colloquium, a conference showcasing the most recent findings in quantitative finance research.