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.     

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.     

On the Choice of Superannuation Funds in Australia

Using a sample of Australian retail and wholesale superannuation funds to proxy for choice and limited choice alternatives, respectively, we investigate the costs and benefits of providing choice to investors. We find that investors who have choice don't respond to fees. Also, loads - typical of the choice environment - are likely to be a dead-weight loss borne by investors. Employees who involuntarily contribute to (employer) funds, tend to pay the lowest fees. Given these results, the advantages of choice become questionable. Our results show that managers of limited choice funds achieve greater positive abnormal returns than retail fund managers. The analysis of flows provides insight into why choice funds do not perform better than limited choice funds. Investors are not responding to historical performance as predicted.     

Public Pensions and U.S. Infrastructure Investment: The Perfect Partnership?

Public pension funds have been passive investors in U.S. infrastructure projects for years, serving primarily as limited partners in designated infrastructure funds. However, the continued maturation of U.S. public‐private partnerships, combined with pension funds' need for yield to match future liabilities, has prompted the funds to take a more active role in infrastructure investment. In recent years, many pension funds have built internal teams to make direct (as opposed to indirect and for the most part passive) investments in infrastructure projects. Governments in particular should pay close attention to the emergence of pension funds as direct infrastructure investors. With OECD pension assets totaling $10.6 trillion at the end of 2010, the world's pension funds offer governments a strong value proposition. Given the fixed nature of their pension liabilities, pension funds emphasize yield and long‐term appreciation, and are likely to accept rate of returns in the neighborhood of CPI + 5%. Infrastructure investments, which generate highly stable cashflow and enjoy high barriers to entry, are ideally suited to meet these criteria. Also of particular significance to governments, pension funds have two bottom lines. First is expected yield and returns; second is their desire to invest in projects that meet a mission of social responsibility. Pension investors prefer, when possible, to invest in projects that promote government objectives such as reduced congestion and clean air. Taking account of pension funds' double mission can help governments capture opportunities to develop infrastructure through meaningful partnerships with like‐minded investors.     

The economics of PIPEs

Private investments in public equities (PIPEs) are an important source of finance for public corporations. PIPE investor returns decline with holding periods, while time to exit depends on the issue's registration status and underlying liquidity. We estimate PIPE investor returns adjusting for these factors. Our analysis, which is the first to estimate returns to investors rather than issuers, indicates that the average PIPE investor holds the stock for 384 days and earns an abnormal return of 19.7%. More constrained firms tend to issue PIPEs to hedge funds and private equity funds in offerings that have higher expected returns and higher volatility. PIPE investors’ abnormal returns appear to reflect compensation for providing capital to financially constrained firms.     

Socially responsible investment funds: Investor reaction to current and past returns

This paper investigates and compares the determinants of fund flows for socially responsible investment (SRI) funds and conventional funds. We consider the impact of current and past measures of monthly and annual return on fund flow. The results suggest SRI fund flows are less sensitive to returns than conventional funds. Our model also shows that flow is persistent and SRI investors are more likely to invest in a fund they already own relative to conventional investors. These results reflect the difficulty SRI investors face in finding alternative investments that meet their non-financial goals.     

Information,sophistication, and foreign versus domestic investors’ performance

Using an intraday transaction dataset with trader identity, we study foreign and domestic investors’ trading activities and investment performance ahead of open-ending events of Taiwanese closed-end funds. Simply buying the funds at a discount and holding until open-ending generates large abnormal returns. All information required to execute this strategy is made public, so the events set up natural experiments to examine how investors trade, holding constant access to information. Foreign investors are net buyers ahead of the open-endings, more than doubling their positions and earning large abnormal returns. Domestic investors are net sellers while the discounts are still large, and forego large abnormal returns. The results suggest that investor sophistication in interpreting the same information is potentially an important determinant of investment performance differences across foreign and domestic investors.     

Measuring Institutional Investors’ Skill at Making Private Equity Investments

Using a large sample of institutional investors’ investments in private equity funds raised between 1991 and 2011, we estimate the extent to which investors’ skill affects their returns. Bootstrap analyses show that the variance of actual performance is higher than would be expected by chance, suggesting that some investors consistently outperform. Extending the Bayesian approach of Korteweg and Sorensen, we estimate that a one‐standard‐deviation increase in skill leads to an increase in annual returns of between one and two percentage points. These results are stronger in the earlier part of the sample period and for venture funds.     

Equity fund size and growth: Implications for performance and selection

Should individuals choose the largest or smallest equity funds for investment? This study explores the relationship of equity fund size to performance. Historical returns of large funds are found to be superior to their smaller peers. Yesterday's best performing fund's tend to become today's largest funds as individuals invest heavily in response to the communications about the fund's past success. But the findings suggest that, once large, equity funds do not outperform their peers. Especially for funds in aggressive growth objectives, the advantages of being small appear to outweigh the disadvantages. For individual investors wtih aggressive growth objectives, a strategy of investing in smaller funds may thus be wealth maximizing.     

Stochastic dominance analysis of Asian hedge funds

We employ the stochastic dominance approach that utilizes the entire return distribution to rank the performance of Asian hedge funds as traditional mean-variance and CAPM approaches could be inappropriate given the nature of non-normal returns. We find both first-order and higher-order stochastic dominance relationships amongst the funds and conclude that investors would be better off by investing in the first-order dominant funds to maximize their expected wealth. By investing in higher-order dominant funds, risk-averse investors can maximize their expected utilities but not their wealth. In addition, we find the common characteristic for most pairs of funds is that one fund is preferred to another in the negative domain whereas the preference reverses in the positive domain. We conclude that the stochastic dominance approach is more appropriate compared with traditional approaches as a filter in hedge fund selection. Compared with traditional approaches, the SD approach, not only is assumption free, but also provides greater insights to the performance and risk inherent in a hedge fund's track record.     

Mutual fund flows and investor returns: An empirical examination of fund investor timing ability

We examine the timing ability of mutual fund investors using cash flow data at the individual fund level. Over 1991–2004 equity fund investor timing decisions reduce fund investor average returns by 1.56% annually. Underperformance due to poor timing is greater in load funds and funds with relatively large risk-adjusted returns. In particular, the magnitude of investor underperformance due to poor timing largely offsets the risk-adjusted alpha gains offered by good-performing funds. Investors in both actively managed funds and index funds exhibit poor investment timing. We demonstrate that our empirical results are consistent with investor return-chasing behavior.     

A comparative performance of conventional and Islamic unit trusts: Market timing and persistence evidence

It is expected that the returns and resistance of Islamic mutual funds will be different from conventional mutual funds as the former have limited choices for portfolio diversification. This article analyses the performance of conventional and Islamic unit trusts for the period February 1995 to July 2012 in the Malaysian market, one of the most developed Islamic mutual fund markets. The performance analysis is based on four parameters: (i) risk-adjusted returns of unit trusts; (ii) market timing abilities; (iii) selection performance; and (iv) persistence. The results of this study suggest that the returns of both conventional and Islamic unit trusts have outperformed the market throughout the sample period. The results for market timing and selectivity are mostly the same for both categories of funds. However, Islamic unit trusts seem to have better resistance to market downturn than conventional unit trusts. The results of this research can be used by investors to identify funds or create portfolios that are more suitable for a recessionary scenario and for fund managers to better manage their portfolio performance during times when markets are likely to fall. The findings in this article are highly relevant for policymakers, investors and fund managers to determine policy matters, deciding on investment and marketing strategy for Islamic mutual funds.     

Climate change news sensitivity and mutual fund performance

In the presence of rising concern about climate change that potentially affects risk and return of investors' portfolio companies, active investors might have dispersed climate change risk exposures. We compute mutual fund covariance with market-wide climate change news index and find that high (positive) climate news beta funds outperform low (negative) climate news beta funds by 0.24% per month on a risk-adjusted basis. High climate news beta funds tilt their holdings toward stocks with high potential to hedge against climate change news risk. In the cross section, such stocks yield higher excess returns, which are driven by greater pricing pressure and superior financial performance over our sample period.     

Excess Volatility and UK Investment Trusts

Abstract:   The issue of whether or not asset prices are more volatile than the underlying fundamentals is an empirical question with implications for market efficiency. Recent research suggests that the volatility of closed end fund returns in the USA is significantly higher than the returns on assets held by the funds. This has been attributed to noise trading as closed‐end fund shares are predominantly held by individual investors. This study demonstrates that UK investment trust returns exhibit similar excess volatility in spite of the prevalence of institutional investors. However, big investment trusts in terms of market capitalisation show greater excess volatility than small trusts. Although most of the excess volatility appears to be idiosyncratic, investor sentiment index is the most important variable associated with residual returns.     

Expected long-term rates of return when short-term returns are serially correlated

When short-term returns are serially uncorrelated, expected long-term and short-term returns are equal. However, we show that negative serial correlation among the short-term returns make the expected long-term returns lower than the short-term ones. Such serial correlation is likely to arise, for example, for an investor whose portfolio is invested abroad in assets denominated in foreign currencies, but who wants to make withdrawals in proportion to the fund's value in the domestic currency, and the exchange rate obeys long-term purchasing-power parity. Small-country sovereign wealth funds are leading examples of such investors. For the Norwegian GPFG, the expected annualized long-term rate of return in Norwegian kroner may be 0.7 to 1.8 percentage points lower than the expected short-term return. Negative contemporaneous correlation between global returns and changes in the real exchange rate may dampen and even reverse this result. Empirical evidence suggests that this may be the case for investors in USD-denominated assets domiciled in the United Kingdom, but not for investors domiciled in Norway or Germany. Empirically, we furthermore find that long-term annualized returns may fall short of short-term returns even when evaluated in real USD. Although negative serial correlation also shrinks the long-term variance, funds such as the GPFG should calibrate withdrawals to the expected long-term returns rather than the short-term ones.     

A note on fair value pricing of mutual funds

Mutual funds claim that they employ fair value pricing to prevent active investors from trading on their beliefs that the funds’ net asset values are stale. Our results support the funds’ assertions. We estimate the returns from the following active strategy: buy international open end mutual funds that do not employ fair value pricing on days that the S&P500 index rises by a large amount, and/or sell them on days that the S&P500 index declines by a large amount. These active strategies significantly outperform pure buy-and-hold strategies. We conclude that international mutual funds should make greater use of fair value pricing.     

Is ethical money financially smart? Nonfinancial attributes and money flows of socially responsible investment funds

We study the money flows into and out of socially responsible investment (SRI) funds around the world. In their investment decisions, investors in SRI funds may be more concerned with ethical or social issues than with fund performance. Therefore, SRI money flows are less related to past fund returns. Ethical money is less sensitive to past negative returns than are conventional fund flows, especially when SRI funds primarily use negative or Sin/Ethical screens. Social attributes of SRI funds weaken the relation between money inflows and past positive returns. However, money flows into funds with environmental screens are more sensitive to past positive returns than are conventional fund flows. Stock picking based on in-house SRI research increases the money flows. These results give evidence on the role of nonfinancial attributes, which induce heterogeneity of investor clienteles within SRI funds. We find no evidence of a smart money effect, as the funds that receive more inflows neither outperform nor underperform their benchmarks or conventional funds.     

Why Do Investors Hold Socially Responsible Mutual Funds?

To understand why investors hold socially responsible mutual funds, we link administrative data to survey responses and behavior in incentivized experiments. We find that both social preferences and social signaling explain socially responsible investment (SRI) decisions. Financial motives play less of a role. Socially responsible investors in our sample expect to earn lower returns on SRI funds than on conventional funds and pay higher management fees. This suggests that investors are willing to forgo financial performance in order to invest in accordance with their social preferences.     

Portfolio Distortions Among Institutional Investors: Evidence from China

The behavior of institutional investors often deviates from established personal or social norms; this deviation may reflect either an informational advantage or a psychological bias. In this paper, we investigate the reasons Chinese mutual funds hold lottery-type stocks, which are characterized by low average returns and high risk. We find that funds at the aggregate level do not exhibit a propensity to gamble, but when they do gamble, they earn abnormal returns on lottery-type investments. Gambling-related outperformance is greater among held firms with characteristics that enable fund managers to obtain more informational advantages. Our results suggest that portfolio distortion is driven by the ability of managers to capitalize private information rather than by behavioral bias.     

Limits to mutual funds' ability to rely on mean/variance optimization

Our evidence suggests that estimation error in the required statistics is an important factor inhibiting investors' ability to rely on mean/variance analysis. We compare the returns reported by mutual funds to the returns obtained from a mean/variance optimized portfolio of fund holdings. The results suggest that funds tend to outperform the optimized portfolio out-of-sample (when means/variances/covariances are unknown), but under-perform in-sample (when the required statistics in the optimization are known). Therefore, a popular assumption in asset pricing models that investors rely on a basic mean/variance analysis with known underlying statistics is likely to be grossly violated in the case of mutual funds.