On evaluating the style-selection skill of hedge funds

A distinctive feature of hedge funds is their dynamic style of trading; hedge funds may shift the investment style in their lifetime. Style shifting is a strategic decision for funds which is beyond the more traditional stock-picking and market-timing carried out at the operational level. This paper tests and validates the performance implications of style-selection skill of hedge funds. Based on the trading style identification through Probabilistic Principal Component Analysis and the measure of style-selection skill developed in this paper, we find that such skill has predictive power for future fund performance, persisting for up to one year. In addition, our findings reveal that funds exhibiting greater style-selection skill enhance the probability of survival. Furthermore, we show that smaller, solo-managed funds operated by managers with longer tenure and higher management fees tend to have greater style-selection skill. Our findings support investors’ decisions when selecting hedge funds. It also opens a new perspective for managerial skills in active money management, reflecting managers’ expertise in data processing about micro and macro information and shocks to achieve success, when considering the investment style.