Should hedge funds deviate from the benchmark?

Abstract

We examine the relationship between deviating from the benchmark and subsequent performance for hedge funds. We propose a simple new measure of benchmark deviations, termed the dispersion contribution index, which is based on a fund's return-distance from the mean return of same-style funds. We find that funds which deviate the most from their benchmark tend to underperform relative to their less distinctive peers, after accounting for their risk profile and various fund characteristics. This relative underperformance stems primarily from the higher subsequent risk exposure associated with pursuing a unique strategy. Our results are indicative of risk shifting by fund managers attempting to maximize the value of their compensation contracts.