Strategy Distinctiveness and Hedge Fund Performance

Presumably, hedge fund managers pursue unique strategies because they have great new ideas and superior investment skills, while less skilled managers are more likely to herd and follow publicly known investment ideas. For investors, knowing how innovative and skillful their managers are is thus extremely important but very difficult because of the opaque nature of hedge fund operations. In this paper, we construct a measure of the distinctiveness of a fund’s investment strategy based on historical fund return data. Specifically, we examine the R-square of a regression of individual hedge fund returns against the average returns of its peer funds. We term (1 – R) the “Hedge Fund Strategy Distinctiveness Index” (SDI), which measures the extent to which a fund’s investment strategy differs from the strategies of the peer funds. We document a substantial cross-sectional variation in SDI as well as strong persistence in fund SDI for up to five years. Our main result indicates that, on average, higher SDI is associated with better subsequent performance.