The Road Less Traveled: Strategy Distinctiveness and Hedge Fund Performance

Presumably, hedge fund managers pursue unique strategies, because they possess innovative ideas and superior investment skills, while less skilled managers are more likely to herd and follow publicly known investment strategies. For investors, knowing how innovative and skillful their managers are is thus extremely important but 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 extent to which a fund’s returns differ from those of its peer funds. We term the measure the “Strategy Distinctiveness Index” (SDI). The higher the SDI, the more distinctive is a fund’s strategy. We document a substantial cross-sectional variation, as well as strong persistence over time in funds’ SDI. Our main result indicates that, on average, a higher SDI is associated with better subsequent performance. Funds in the highest SDI quintile significantly outperform funds in the lowest SDI quintile by about 4% over the subsequent year after risk adjustment.