New research from the European School of Management & Technology (ESMT), in collaboration with the Rotterdam School of Management, highlights a worrying disconnect in the behaviour of investors in hedge funds and the subsequent performance of their investments, typically resulting in poor or volatile performance and exposure to unnecessary risk.

In a study of hedge fund performance according to investment style, covering 1,543 hedge funds over 10 years, ESMT's research raises disturbing questions about the way that hedge fund investors invest and their willingness to actively chase performance at all costs, irrespective of the potential level of risk to which they are exposed. As a result, the authors of the research take the view that greater regulation is necessary to protect investors and that the provisions of the controversial Alternative Investment Fund Managers (Directive) ought to be welcomed.

The research reveals that investors systematically reward investment styles that have performed well over the previous three quarters, effectively substituting different investment styles for one another regardless of whether they are taking on higher levels of risk. This results in the top performing investment style attracting nearly $300 million more capital than the investment style that performs most poorly.

A differential of 1 per cent in the performance of a given style attracts a further $9 million of investor funds. However, the volatility of hedge fund styles means that high performing investment styles often go on to underperform other investment styles in subsequent quarters.

The importance of ESMT's research is that it is the first of its kind to show correlated investment behaviour based on style. Previous studies have not separated style-based investing from those investors rewarding the performance of individual funds or managers. ESMT calculates that approximately 13 per cent of total net asset growth can be attributed to "style-based investing", and 20 per cent of the capital that is committed to the hedge fund sector.

The ramifications of style-based investment are significant, with the research suggesting that focusing on investment styles results in a potential inefficient allocation of capital across the hedge fund sector. The danger is that as increasing amounts of capital chase given styles (potentially attracting more managers into that style in turn), momentum investment starts to take hold, forcing up the price of overheated securities.

Guillermo Baquero, Assistant Professor at the European School of Management & Technology (ESMT) and an author of the research comments: "We have a two-fold issue here: whether investors' naivety is leaving them overly exposed to risk they are not properly evaluating, and whether the growth of the hedge fund industry combined with that naivety means the sector poses a threat to financial stability. The fact that investors appear unable to recognise the risks of different styles and chase performance at all costs could leave them vulnerable and unprotected. This is exacerbated at the individual fund level by the opacity and lack of regulation of the sector, which already means that there are significant discrepancies in the level and quality of information reported.

"We should not be scared to tighten the regulatory screw on the hedge fund industry and force considerably greater disclosure. Now is the time to discuss deep, substantial and effective regulation that will genuinely be of use to investors and protect our financial system for the future."