Sensation Seeking and Hedge Funds

• DOI: http://doi.org/10.1111/jofi.12723
• Author: MELVYN TEO,YAN LU,SUGATA RAY,STEPHEN BROWN
• Published date: 01 December 2018
• Date: 01 December 2018

THE JOURNAL OF FINANCE •VOL. LXXIII, NO. 6 •DECEMBER 2018

Sensation Seeking and Hedge Funds

STEPHEN BROWN, YAN LU, SUGATA RAY, and MELVYN TEO∗

ABSTRACT

We show that, motivated by sensation seeking, hedge fund managers who own pow-

erful sports cars take on more investment risk but do not deliver higher returns,

resulting in lower Sharpe ratios, information ratios, and alphas. Moreover,sensation-

seeking managers trade more frequently, actively, and unconventionally, and prefer

lottery-like stocks. We show further that some investors are themselves susceptible to

sensation seeking and that sensation-seeking investors fuel the demand for sensation-

seeking managers. While investors perceive sensation seekers to be less competent,

they do not fully appreciate the superior investment skills of sensation-avoiding fund

managers.

“The emerging manager who goes out and buys a fancy sports car right off

the bat is someone you probably want to avoid.”

—Business Insider, February 20161

∗Stephen Brown is at Monash Business School and New York University, Stern School of Busi-

ness. YanLu is at College of Business, University of Central Florida. Sugata Ray is at Culverhouse

College of Business, University of Alabama. Melvyn Teo is at Lee Kong Chian School of Business,

Singapore Management University. We are deeply grateful to two anonymous referees, an Asso-

ciate Editor and Wei Xiong (the Editor) for helpful suggestions and comments. We also benefitted

from conversations with Malcolm Baker; Michael Brennan; Matthew Cainl Darwin Choi; Jennifer

Conrad; Elroy Dimson; Rich Evans; Ken Froot; Wes Gray; Marty Gruber; Danling Jiang; Matti

Keloharju; Min Kim; Marc Lipson; Deborah Lucas; David Nawrocki; Richard Roll; Steve Satchell;

Bill Sharpe; Andrei Shleifer; Rob Stambaugh; Laura Starks; Jeremy Stein; Neng Wang; Ingrid

Werner; Tina Yang; and Jingjing Zhang as well as seminar participants at Chinese University of

Hong Kong, Deakin University,KAIST, Massey University,Nanyang Technological University,Sin-

gapore Management University, University of Queensland, University of Stony Brook, University

of Sydney, the 2017 Monash University Q Group Colloquium, the University of Melbourne 2017

Financial Institutions, Regulation, and Corporate Governance conference, the 2017 Mid-Atlantic

Research Conference in Finance, the 2017 World Investment Forum, the 2017 Investment Man-

agement Research Conference at the University of Technology, Sydney, and the 7th Behavioural

Finance and Capital Markets Conference 2017 at La Trobe University. Korey Adkins, Nick De-

robertis, Antonia Kirilova, Charles Lowell IV, and Luqi (Emma) Xu provided excellent research

assistance. We are indebted to Autocheck and especially to Pierre Parent for providing access to

the automobile data. Teo acknowledges support from the Singapore Ministry of Education (MOE)

Academic Research Tier 2 grant with the MOE’s official grant number MOE 2014-T2-1-174. This

work was awarded the 2017 Jack Treynor Prize by the Q Group (The Institute for Quantitative

Research in Finance). We have read the Journal of Finance’sdisclosure policy and have no conflicts

of interest to disclose.

1See “Bad coffee and a red Ferrari: Here are some of the ‘red flags’ at new hedge funds” by Julia

La Roche Business Insider, February 18, 2016. The article further describes this as the classic “red

Ferrari syndrome.”

DOI: 10.1111/jofi.12723

2871

2872 The Journal of Finance R

DO THE PERSONALITY TRAITS OF PROFESSIONAL FUND managers shape their in-

vestment behavior? Extant academic literature on the role of personality traits

in finance has focused predominantly on retail investors. Salient examples of

such work include Barber and Odean (2000,2001) and Grinblatt and Keloharju

(2009). However, given the amount of capital that some fund managers manage

and the potential for their trading behavior to impose negative externalities

on their underlying investors, an analysis of how personality impacts trading

is arguably even more important for investment managers than for individual

investors. This paper helps fill this void by evaluating fund managers’ procliv-

ity for sensation seeking using novel automobile ownership data and analyzing

their investment behavior.

Sensation seeking is a personality trait clinically defined as the seeking of

varied, novel, complex, and intense sensations and experiences, and the will-

ingness to take physical, social, legal, and financial risks for the sake of such

experiences. It has been linked to the propensity to engage in risky driving,

extreme sports, substance abuse, and crime (Zuckerman (1994,2007)).2We

show that, motivated by sensation seeking, some hedge fund managers take

substantial financial and operational risks for nonpecuniary reasons unrelated

to performance, and that the incremental risk-taking ultimately hurts their

investors. Our work adds to an emerging literature on the impact of sensation

seeking on retail investors (Grinblatt and Keloharju (2009)), chief executive of-

ficers (CEOs) (Cain and McKeon (2016) and Sunder, Sunder, and Zhang (2017)),

and households (Bochkay et al. (2018)).

The hedge fund industry is an important and interesting laboratory for ex-

ploring the impact of sensation seeking on finance. Hedge funds collectively

managed over US$3.3 trillion in assets in 2017.3The complex, dynamic, and

relatively unconstrained strategies that hedge fund managers employ, which

often involve short sales, leverage, and derivatives, may attract sensation seek-

ers by satisfying their desire for varied, novel, complex, and intense expe-

riences. Indeed, professional traders often describe trading as addictive given

the adrenaline rush they derive from placing big wagers.4Neuroscientists have

found that, in the human brain, monetary gain stimulates the same reward cir-

cuitry as cocaine (Breiter et al. (2001)).5Sensation seekers may also be drawn

2While sensation seeking may imply greater risk-taking, the taking of risk does not necessarily

imply sensation seeking. The elevated risk-taking of sensation seekers is simply a by-product of

their preference for varied, novel, complex, and intense experiences. Zuckerman (2007) notes that

“ . .. sensation seekers do not seek risk for its own sake. It is not the riskiness of their activities

that make them rewarding. In fact, many or most experiences sought by sensation seekers are not

at all risky. Listening to rock music; partying with interesting, stimulating people; and looking

at intensely erotic or violent movies or television involve no risk. However, other types of activities

such as driving very fast, engaging in extreme sports, getting drunk or high on drugs, and having

unprotected sex with a variety of partners, do involve risk.”

3See https://www.barclayhedge.com/research/money_under_management.html.

4See, for example, “A disgraced trader’s struggle for redemption,” by David Enrich Wall Street

Journal, April 29, 2016.

5Kuhnen and Knutson (2005) present evidence that supports a neural basis for financial

risk-taking.

Sensation Seeking and Hedge Funds 2873

to the industry’s limited transparency and regulatory oversight, which imply

fewer constraints on trading behavior. Seemingly wary of the impact of sensa-

tion seeking on trading behavior, some hedge fund allocators argue that the

purchase of a performance sports car or the pursuit of risky leisure activities

by a manager raises red flags about her fund (Strachman (2008)).

Prior research has used data on speeding tickets (Grinblatt and Keloharju

(2009)), pilot licenses (Cain and McKeon (2016) and Sunder, Sunder, and Zhang

(2017)), and extramarital affairs (Bochkay et al. (2018)) to identify sensation

seekers. By using the characteristics of vehicles purchased, such as body style,

maximum horsepower,maximum torque, passenger volume, and safety ratings,

as opposed to speeding tickets or pilot licenses, we are able to leverage on a

multiplicity and continuum of signals that increase the power of our tests.6We

argue that, more often than not, the purchase of a powerful sports car conveys

the intent to drive in a spirited fashion and therefore signals an inclination for

sensation seeking.7Jonah (1997) reviews the link between sensation seeking

and risky driving. Conversely,we contend that the acquisition of a practical but

unexciting vehicle such as a minivan reflects an aversion to sensation seeking.8

The empirical results are striking. We find that hedge fund managers who

purchase performance cars take on more investment risk than do fund man-

agers who eschew performance cars. Specifically, sports car drivers exhibit an-

nualized return standard deviations that are 1.80 percentage points, or 16.61%,

higher than those of nonsports car drivers. Similarly,funds managed by drivers

of high horsepower and high torque automobiles deliver more volatile returns.

Conversely, we find that managers who acquire practical but unexciting cars

take on less investment risk relative to managers who shun these cars. Mini-

van owners, for example, generate annualized return standard deviations that

are 1.28 percentage points, or 11.74%, lower than do other owners. Moreover,

managers who purchase cars with high passenger volumes and excellent safety

ratings also produce more stable returns.

The incremental risk-taking by sensation seekers does not benefit their

clients. Buyers of cars with prosensation attributes (sports car ownership,

horsepower, and torque) deliver lower Sharpe ratios and information ratios

than do buyers of cars with antisensation attributes (minivan ownership, pas-

senger volume, and safety rating). For example, sports car owners generate

annualized Sharpe ratios and information ratios that are on average 0.39 and

0.29 lower, respectively, than those generated by other car owners. Indeed, we

6Moreover, this allows us to sidestep concerns about how travel mileage, traffic enforcement

activity, situational awareness behind the wheel, access to a good lawyer, as well as the use of

radar-detecting and laser-jamming devices can affect the probability of receiving a traffic citation

conditional on speeding.

7In an ideal world, we would assess hedge fund managers by using the battery of tests developed

in the psychology literature to gauge sensation seeking (see Zuckerman (2007)). However,as Brown

et al. (2012) have shown, hedge fund managers may not always tell the truth.

8Articles in the popular press that describe minivans as dowdy,stodgy, and uncool lend support

to this view. See, for example, “Operation: minivan,” by Jonathan Welsh Wall Street Journal,

August 7, 2003.