Investor Behavior in Hedged Mutual Funds: Evidence on Risk Chasing and Misallocation

Hedged mutual funds (HMFs), employing hedge-fund-like strategies such as leverage, short-selling, and derivatives, have become a significant segment of the U.S. fund industry. These strategies generate returns tied to nontraditional or exotic risk factors, raising the question of whether investors can distinguish managerial skill from HMFS’ exotic risk exposures. Using U.S. data from 1994–2023, we examine fund flows with portfolio sorts, Fama–MacBeth regressions, and sentiment-based tests. We find that the apparent outperformance of positive-flow funds disappears once exotic risk factors are accounted for using the Fung–Hsieh (2001, 2004) model. Flows respond strongly to raw returns and Carhart alphas but not to Fung–Hsieh alphas, and they increase with exotic-risk exposures. These effects are concentrated in high-sentiment periods and among retail investors-tilted funds. Overall, our results show that HMF investors chase risk exposures rather than skill, amplifying misallocation risks in complex products.