What institutional investors can learn from a hedge fund’s writing style

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Strategy Presentation Background in Blue and White © Kheng Ho Toh /123RF Stock Photos It turns out institutional investors can learn a lot about hedge funds by paying attention to their writing style.

In fact, when looking at hedge funds’ strategy descriptions, the sophistication of the text can be telling, according to a new research paper.

“It seems that even for sophisticated entities such as hedge funds — that could basically hire somebody to write their strategy descriptions and could do strategy descriptions that are boilerplate and don’t mean anything — there is information even in that,” says Cristian Tiu, chair and associate professor of finance at the University of Buffalo and one of the paper’s co-authors.

Particularly, hedge funds with “lexically diverse” descriptions outperform, eschew tail risk and have fewer regulatory problems, the research found. Lexical diversity is when writers use multiple synonyms instead of repeating words.

Also, funds with “syntactically complex” descriptions report more regulatory violations and severe infractions. Syntactic complexity is when writers use complicated sentences and heavy subordination.

When looking at linguistics and psychology literature, writing style can predict performance or intent to deceive, notes Tiu. “For example, propensity to use a lot of synonyms rather than repeating words in a text — that predicts quality and also predicts honesty. Whereas, a writing style that is complicated because you use overly complicated sentence structure — syntactic complexity —that predicts that you have something to hide.”

The research found a greater investment flow to funds with high lexical diversity compared to those with low lexical diversity. However, it noted the capital allocated to these funds isn’t enough to erode positive alphas.

“Our predictive results that hedge funds that have strategy descriptions that are lexically diverse, for example, that these funds outperform — this has not been exhausted. So there is room for more. If investors pick these funds then there’s still alpha left.”

The full paper is available at SSRN: https://ssrn.com/abstract=3438758.

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