Hedge funds with "powerful" names are more popular — but they perform worse. Here's why.

ByJames Dennin

Is your Kentucky Derby strategy to bet on the horse with the coolest-sounding name? Turns out you have something in common with wealthy investors.

Many seem to choose hedge funds using a similarly unsophisticated method, at least according to a new study from professors at the University of Oulu and University at Buffalo.

Specifically, hedge fund investors are swayed by names with "gravitas," which the authors defined as a series of words denoting "geopolitics and economics, or suggesting power." But here's the rub: The researchers, who started with a sample of more than 17,000 hedge funds, also found that funds with these alpha-sounding names actually performed worse across several measures. They had lower returns, the report found, and carried more risk.

Why does "gravitas" attract investors?

The economic effects of adding a little heft to a name are considerable: Including just one additional serious word was found to bring in an extra $250,000 in capital each year, according to the study authors. What kind of words? Fund names with the top scores for gravitas included words like "prodigy," "Newtonian," and "dynamic," the researchers told Quartz.

Additionally, it might not simply be the words, but rather "the mixture of words that you see" creating the gravitas effect, study author Cristian Ioan Tiu told Mic. "So if a fund is called 'Russian Macro Arbitrage Fund,' it has ... the name of a country and an economic term," which both connote seriousness.

On the other end of the spectrum? The controversial — if historically successful — Bridgewater Associates: "One of the names that had the least amount of gravitas is Bridgewater Associates," Tiu said. "None of those names suggest terms from politics, so Bridgewater has low gravitas."

On the whole, it's not particularly surprising that certain names stick better than others. Investors are similarly irrational when it comes to buying stocks, too, research has found, and equities with names beginning with letters early in the alphabet tend to be valued higher than "late-alphabet" stocks. Lucky for Apple!

Names are so important that having a memorable one that resonates with customers can be incredibly valuable: Companies pay up to $75,000 to branding consultants to work on their name, according to the New York Times

But hedge funds with powerful names actually performed worse

Hypothetically, paying $75,000 for a name that nets you an extra $250,000 seems solid. Unfortunately, a great name doesn't always translate into a great strategy — and hype can actually backfire when expectations surpass reality.

In fact, the funds with more powerful-sounding names actually tended to have lower returns, the report found, and carried more risk than relevant industry benchmarks. And as time went on, hedge funds whose names displayed gravitas were also more likely to go out of business. Why is that?

One possibility, Tiu said, is that less competent managers tend to be the ones who work harder on marketing considerations — like choosing a name.

"If you feel the need to tell others how good you are and actually know what you're talking about, then somebody may ask why do you feel the need," he said. "It may not be that strategic."

Hedge fund investors should be smarter than to fall for a puffed-up name though, right? Typically held by the super-rich and institutional investors, hedge funds are less regulated than mutual funds targeting everyday retirement savers. But the fact that these investors put such a premium on flashy-sounding names suggests they are subject to the same biases as less sophisticated investors.

The lesson? Pay less mind to flashy names and more attention to the fees on funds you hold in your retirement accounts, since expenses tend to make a big difference as to which investments perform best. Index funds and automated holdings tend to be smarter than expensive funds — and boring is often better. 

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