This thesis examines the degree to which alternative funds deviate from theirstyle-benchmark and how this is related to past performance and fund size, andhow it impacts future risk and returns. Additionally the thesis examines howsecurity selection and market timing skills differ across varying degrees ofdeviation from the benchmark. The thesis uses data for hedge funds, funds offunds, and CTA funds from the Center for International Securities and DerivativesMarkets and employs funds tracking error relative to their style-benchmark toestimate the level of drift. The style-benchmarks used are the median return for allreporting funds that follow a particular style and funds are assigned a benchmarkbased on their self-reported style. First, this thesis documents statisticallysignificant differences in the tracking errors of portfolios of funds with the highesttracking error versus funds with the lowest tracking error, implying that somemanagers drift from their self-reported style-benchmarks. Second, fundsbenchmark-inconsistency is less severe in the case of funds that have a regulatoryobligation to disclose their performance, suggesting that the absence of regulationfosters an environment where managers can be more flexible with theirinvestment approach. Third, the tendency to drift from the benchmark is mostprevalent amongst funds with superior past performance as well as small funds.Fourth, future total portfolio risk increases as funds display more benchmarkinconsistency,suggesting that managers adopt riskier strategies as they attempt toenhance returns. Fifth, the thesis demonstrates that CTA funds that display driftfrom their benchmark produce higher absolute and relative returns in subsequentperiods regardless of the direction of the general market. In contrast, the findingsshow for hedge funds and funds of funds, benchmark-inconsistent funds are likelyto outperform in bull markets and underperform in bear markets. Finally, thisthesis shows that more benchmark-consistent managers have better securityselection skill. The main contribution of this thesis is in identifying the group ofhedge funds, funds of funds, and CTA funds that are likely to deviate from theirself-reported style-benchmark and the risk-return consequences of suchdeviations. The findings have implications for investors and regulators.
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