This paper shows the results of mutual funds (traditional asset managers) are primarily determined by where the mutual fund invests. That is, mutual funds are primarily traditional asset managers who follow a style box and benchmark. Therefore, mutual funds are typically highly correlated to their benchmark or style box or sector. They are typically fully invested based on their stylized mandate for relative return vs. some index or benchmark. Their performance results are achieved by "what" or "where" they invest in (asset location).

Conversely, Fung and Hsieh show that alternative managers results are created more by "how they trade". That is, alternative asset managers results are determined by their trading strategy, not the more passive location (or allocation) of assets.

Abstract:

This paper presents some new results on an unexplored data set on hedge fund performance. The results indicate that hedge funds follow strategies that are dramatically different from mutual funds, and support the claim that these strategies are highly dynamic. The paper finds five dominant investment styles in hedge funds, which, when added to Sharpe's (1992) asset class factor model, can provide an integrated framework for style analysis of both buy-and-hold and dynamic trading strategies.

An Excert:

The success of Sharpe’s (1992) approach is due to the fact that
most mutual fund managers have investment mandates similar to traditional asset managers with relative return targets. They are typically constrained to hold assets in a well-defined number of asset classes and are frequently limited to little or no leverage. Their mandates are to meet or exceed the returns on their asset classes. Therefore they are likely to generate returns that tend to be highly correlated to the returns of standard asset classes. Consequently, stylistic differences between managers are primarily due to the assets in their portfolios, which are readily captured in Sharpe’s (1992) “style regressions.”

In this article, we propose an extension to Sharpe’s (1992) model for
analyzing investment management styles. The objective is to have an
integrated framework for analyzing traditional managers with relative
return targets, as well as alternative managers with absolute return
targets. These alternative managers tend to generate returns that are less correlated to those of standard asset classes. Consequently, the original Sharpe (1992) model must be modified to capture the stylistic differences of these alternative managers.

In particular we focus on hedge fund managers and commodity
trading advisors (CTAs). This is an important class of managers
within the category of “alternative managers.” Hedge fund managers
and CTAs typically have mandates to make an absolute return target, regardless of the market environment. To achieve the absolute return target, they are given the flexibility to choose among many asset classes and to employ dynamic trading strategies that frequently involve short sales, leverage, and derivatives. Accordingly, we extend Sharpe’s (1992) asset class factor model to accommodate the differences between these alternative managers’ approaches and those of traditional mutual fund managers.

Our work is based on the intuition that managers’ returns can be
characterized more generally by three key determinants: the returns
from assets in the managers’ portfolios, their trading strategies, and
their use of leverage. In Sharpe’s (1992) model, the focus was on
the first key determinant, the “location” component of return, which
tells us the asset categories the manager invests in. Our model extends

Sharpe’s approach by incorporating factors that reflect “how a
manager trades” — the strategy component of return and the useof “leverage” — the quantity component of return. Adding new factors to Sharpe’s (1992) model allows us to accommodate managers that employ dynamic, leveraged trading strategies. It is these additional factors that provide insight on the strategic difference between “relative return” versus “absolute return” investment styles. Just as Sharpe’s model provides insight to the asset mix decision when only relative return styles are considered, the extended model provides a framework for analyzing the asset mix decision with an absolute return target.

PDF Copy: Dynamic Trading Strategies- The Case of Hedge Funds.pdf

Arms, William Fung and Hsieh, David A., Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds. REVIEW OF FINANCIAL STUDIES, Vol. 10, No. 2. Available at SSRN: http://ssrn.com/abstract=8307