Style chasing by hedge fund investors

This paper examines whether investors chase hedge fund investment styles. We find that better-performing and more popular styles are rewarded with higher inflows in subsequent periods. This indicates that investors compare hedge fund styles in terms of recent performance and popularity, and they subsequently reallocate funds from less successful to more successful styles. Furthermore, we find evidence of competition between individual hedge funds of the same style. Funds outperforming the other funds in their styles and funds whose inflows exceed the average flows in their styles experience higher inflows in subsequent periods. One of the reasons for competition among same-style funds is investors’ search for the best managers. The high minimum investment required to invest in a hedge fund limits investors’ diversification opportunities and makes this search particularly important. Finally, we show that hedge fund investors’ implementation of style chasing in combination with intra-style fund selection represents a smart strategy.     

Capacity constraints,investor information,and hedge fund returns

To identify capacity constraints in hedge funds and simultaneously gauge how well-informed hedge fund investors are, we need measures of investor demand that do not affect deployed hedge fund assets. Using new data on investor interest from a secondary market for hedge funds, this paper verifies the existence of capacity constraints in hedge funds. There is more mixed evidence on the information available to hedge fund investors. Buy and sell indications arrive following fund outperformance. While buy indications have little incremental power to predict hedge fund performance over and above well-known forecasting variables, sell indications do somewhat better.     

Corporate governance and hedge fund activism

Recently, the mainstream media have paid considerable attention to hedge funds behaving as agents of corporate change. We study this phenomenon using a unique dataset of hedge fund activism for the period 1994–2005, and find evidence that hedge fund activists improve both short-term stock performance and long-term operating performance of their targets. The most dramatic changes in performance accrue to targets where activists seek corporate governance changes and reductions in excess cash. Additionally, hedge funds themselves benefit from activism: the risk-adjusted annual performance of hedge funds seeking changes in corporate governance is about 7–11% higher than for non-activist hedge funds and hedge funds pursuing less aggressive activism. These results imply that hedge funds can facilitate long-lasting changes in corporate governance, cash flows, and operating performance that benefit target firm shareholders and hedge fund investors alike.     

Higher risk,lower returns: What hedge fund investors really earn

The returns of hedge fund investors depend not only on the returns of the funds they hold but also on the timing and magnitude of their capital flows in and out of these funds. We use dollar-weighted returns (a form of Internal Rate of Return (IRR)) to assess the properties of actual investor returns on hedge funds and compare them to buy-and-hold fund returns. Our main finding is that annualized dollar-weighted returns are on the magnitude of 3% to 7% lower than corresponding buy-and-hold fund returns. Using factor models of risk and the estimated dollar-weighted performance gap, we find that the real alpha of hedge fund investors is close to zero. In absolute terms, dollar-weighted returns are reliably lower than the return on the Standard & Poor's (S&P) 500 index, and are only marginally higher than the risk-free rate as of the end of 2008. The combined impression from these results is that the return experience of hedge fund investors is much worse than previously thought.     

Hedge fund incentives,management commitment and survivorship

Management ownership in hedge funds sends conflicting signals—signals which reduce investors’ perception of survivorship risk. We document that decisions on management ownership are purposely self-selected. Such decisions are most likely motivated by unique incentive mechanisms imbedded in hedge funds. We examine the impact of managerial ownership decisions on fund survivorship risk by accounting for unobserved fund manager motivations that affect both ownership decisions and survivorship risk. Our findings suggest that the conventional argument that having management commitment can reduce survival risk (and therefore align the interests between managers and investors) is significantly overstated. These results are robust to using alternative ownership measures and controlling for different samples.     

Alpha or beta in the eye of the beholder: What drives hedge fund flows?

Capital Asset Pricing Model (CAPM) alpha explains hedge fund flows better than alphas from more sophisticated models. This suggests that investors pool together sophisticated model alpha with returns from exposures to traditional (except for the market) and exotic risks. We decompose performance into traditional and exotic risk components and find that while investors chase both components, they place greater relative emphasis on returns associated with exotic risk exposures that can only be obtained through hedge funds. However, we find little evidence of persistence in performance from traditional or exotic risks, which cautions against investors’ practice of seeking out risk exposures following periods of recent success.     

Hedge fund liquidity and performance: Evidence from the financial crisis

We investigate how share restrictions affect hedge fund performance in crisis and non-crisis periods. Consistent with prior research, we find that in the pre-crisis period more illiquid funds generate a share illiquidity premium compensating investors for limited liquidity. In the crisis period, this share illiquidity premium turns into an illiquidity discount. Hedge funds with more stringent share restrictions invest more heavily in illiquid assets. While share restrictions enable funds to manage illiquid assets effectively in the pre-crisis period, they seem insufficient to ensure effective management of illiquid portfolios in the crisis. In a crisis period, funds holding illiquid portfolios experience lower returns and alphas, also when share restrictions are controlled for. Funds with an asset–liability mismatch perform particularly poorly and experience the strongest outflows. Share restrictions are also a proxy for incentives as investors cannot immediately withdraw their money after poor performance. We show that higher incentive fees can offset the share illiquidity discount in the crisis period.     

Duration of poor performance and risk shifting by hedge fund managers

A typical hedge fund manager receives greater compensation after strong performance but does not lose compensation after weak performance, and therefore might take on more risk for the second half of the year after poor returns in the first half. We refer to this as “risk shifting.” However, continual risk shifting over a long period would likely make the fund too volatile to attract investors. We find that hedge funds with poor first-half-year performance do tend to increase risk during the second half-year. The effect is larger for funds that began the year “under water” and for smaller funds. The effect is smaller, however, if the poor performance lasts long.     

Alumni social networks and hedge fund performance: Evidence from China

Based on unique data of Chinese private hedge funds, we first construct the “strong alumni” (alumni of the same school and the same major) social networks of private hedge fund managers, and examine the impact of alumni social networks on the performance of hedge funds in China. We build a series of alumni networks using the educational background information of 4734 private hedge funds, and perform an empirical analysis on a sample of 1115 private hedge funds products from 2010 to 2019. Different from previous findings of mutual funds, we find that more central network positions of hedge fund managers are associated with better risk-adjusted fund performance. Hedge fund managers with more central positions conduct more active investment styles and receive lower fund flows.¹ The results supplement the evidence that information advantages brought by central position in social networks can influence managers' investment styles, thus improve hedge fund performance.     

Mutual fund performance when parent firms simultaneously manage hedge funds

This study examines the performance of mutual funds managed by firms that simultaneously manage hedge funds. We find that the reported returns of mutual funds in these “side-by-side” associations with hedge funds significantly underperformed those of mutual funds that shared similar fund and family characteristics but differed in that they were not affiliated with hedge funds. Digging deeper into performance, we find that the underperformance was confined to return gaps, a return measure that captures the impact of unobservable managerial actions. Interestingly, mutual funds with investment styles that were most closely aligned to affiliated hedge funds generated reported-return alphas and return gaps that underperformed by the greatest amount. Finally, we find that side-by-side mutual funds received less of a contribution to performance from IPO underpricing than similar unaffiliated mutual funds or affiliated hedge funds. Evidence does not support the hypothesis that affiliations with hedge funds allow side-by-side mutual funds to attract superior stock-picking talent. Our evidence does not allow us to rule out the possibility that management firms maximized fee income by strategically transferring performance from mutual funds to hedge funds.     

Commonality in hedge fund returns: Driving factors and implications

We measure the commonality in hedge fund returns, identify its main driving factor and analyze its implications for financial stability. We find that hedge funds’ commonality increased significantly from 2003 until 2006. We attribute this rise mainly to the increase in hedge funds’ exposure to emerging market equities, which we identify as a common factor in hedge fund returns over this period. Our results show that funds with a high commonality were affected disproportionately by illiquidity and exhibited negative returns during the subsequent financial crisis, thereby providing little diversification benefits to the financial system and to investors.     

全球流动性过剩、对冲基金发展与中国金融稳定

全球流动性过剩导致全球金融资产激增,推动对冲基金业规模迅速膨胀,也使得对冲基金业在结构和投资动向上也出现了新的变化。对冲基金在全球寻找套利和投机机会,对全球的金融稳定产生一定的影响,在此背景下,中国需要审慎资本项目开放和加强对冲基金的监管。     

Liquidity shocks,size and the relative performance of hedge fund strategies

We examine whether the increase in the flow of capital to hedge funds over the period 1994–2005 had a negative impact on performance. More specifically, we study the relative performance of small versus large funds for each of the hedge fund strategies. Our results indicate that on an absolute return basis, small funds outperform large funds. On a risk-adjusted return basis, however, we find that large funds outperform small funds, and that large funds are also shown to hold less liquid assets and take on less systematic and idiosyncratic risk than small funds. Further, funds that experience positive liquidity shocks generally outperform those that experience negative liquidity shocks. We also find evidence that hedge fund managers that are aggressive in dealing with liquidity shocks perform better than hedge fund managers that are conservative in dealing with liquidity shocks.     

Hedge fund seeding with fees-for-guarantee swaps

This paper introduces a new instrument in the context of hedge fund seeding, which we call fees-for-guarantee swap, with the aim of alleviating the early-stage funds (ESF) managers' financial constraint caused by severe asymmetric information between investors and managers. The swap plays a role in enhancing the ESFs manager's credibility by swapping part of her fees for an insurance on the behalf of seeding investors, whom would be fully refunded once the fund defaults. We set up a dynamic continuous-time framework within which closed-form prices for seed capital, guarantee costs and other claims have been derived. Our numerical findings indicate that incentive compensations, managerial ownership and hedge funds liquidation risks not only inhibit ESFs managers' risk-shifting incentive but align interests among ESFs manager, seeder and insurer as well.     

Share restrictions and asset pricing: Evidence from the hedge fund industry

This paper presents evidence on the relation between hedge fund returns and restrictions imposed by funds that limit the liquidity of fund investors. The excess returns of funds with lockup restrictions are approximately 4–7% per year higher than those of nonlockup funds. The average alpha of all funds is negative or insignificant after controlling for lockups and other share restrictions. Also, a negative relation is found between share restrictions and the liquidity of the fund's portfolio. This suggests that share restrictions allow funds to efficiently manage illiquid assets, and these benefits are captured by investors as a share illiquidity premium.     

Dynamic prediction of hedge fund survival in crisis-prone financial markets

This study focuses on dynamic changes in survival probabilities over the lifetimes of hedge funds. To model such probabilities, a mixed Cox proportional hazards (CPH) model-specifically, a survival/hazard model with time-varying covariates and fixed covariates- is employed. Resulting dynamic survival probabilities show that the mixed CPH model provides significantly higher accuracy in predicting hedge fund failure than other models in the literature, including fixed covariate CPH models and discrete logit models. Our results are useful to investors and regulators of hedge funds in crisis-prone financial markets.     

Diversification in the hedge fund industry

We provide evidence of a significant relation between diversification and performance in the hedge fund industry. Measuring diversification across four distinct dimensions, we find a significant positive relation between hedge fund performance and diversification across sectors and asset classes. We show that on a risk adjusted basis, hedge funds that diversify across sectors and asset classes outperform other funds by an average of 1.1% per year. However, diversification across styles and geographies exhibits a significant negative association with hedge fund returns. Funds that diversify across styles and geographies underperform other funds by an average of 1% per year. For fund of hedge funds, we find a significant positive relation between performance and diversification across sectors. However, diversifying across asset classes and geographies is found to exhibit a negative relation with fund performance. Finally, we find that the motive to engage in diversification is consistent with managerial incentive structure in the hedge fund industry.     

Convenience in the mutual fund industry

I examine the role of convenience in the mutual fund industry. I find that investors pay more for relatively convenient funds, and that the flows to convenient funds are less responsive to performance. These findings suggest that investors do not evaluate mutual funds independently, but rather that investors select a primary fund, likely based on beliefs about managerial ability, and then select funds which are relatively convenient to this primary fund.     

Who Charges More: Hedge Funds or Mutual Funds?*

Explicit mutual fund fees are typically less than 1% of the assets under management. By comparison, the typical hedge fund charges a base fee of 2% plus a performance fee equal to 20% of net profits. Thus, hedge funds appear to charge far more for even comparable performance—unless one takes account of the following:

• ? For most mutual funds, a very high percentage of performance is driven by its passive exposure to the market, even though the fee is applied to the total fund.
• ? Many hedge funds are designed to provide returns that are completely independent of market performance.

Using these two assumptions, the author provides a simple example that shows that a representative mutual fund's performance can be replicated by combining an index fund, which represents the mutual fund's passive component, with a hedge fund, representing the mutual fund's active component. When analyzed in this way, the fee of the combined fund turns out to be remarkably close to the actual fee of the mutual fund. This in turn suggests that the implicit fee for the mutual fund's small active component is comparable to the fees of the hedge fund.     

How skilful are US fixed-income fund managers?

We develop a performance evaluation model that incorporates the factors proposed by Huij and Derwall (2008) and a fund-specific benchmark to analyse the performance of US fixed income funds. Using the full sample, and accounting for the possibility of false discoveries, we find that fund management companies extract most of any abnormal performance produced by their fund managers. Our sub-sample analysis indicates that after the Global Financial Crisis (GFC) there was a substantial increase in the number of bond funds with: both positive gross-of-fee alpha and positive net-of-fee alpha performance; and also a reduction in funds with negative-alpha performance. However, because the GFC was such a unique event, it would still be difficult to conclude that these managers offer value for money for investors compared to passive alternatives.