The role of derivatives in hedge fund activism

Using a hand-collected sample of hedge fund activist engagements from 1994 to 2014, this study analysed the role of derivatives in the hedge fund activism. Evidence shows abnormal returns of targets of hedge fund activists who did not use derivatives exceeded the abnormal returns of targets of hedge fund activists who employed derivatives around the activist engagement disclosure period. We also find that idiosyncratic volatility of the targets of hedge fund activists who did not use derivatives was more reduced than that of the targets of hedge fund activists who used derivatives. Finally, the probability of takeovers increases for hedge fund activists who did not use derivatives.     

Corporate control and shareholder activism in Germany: An empirical analysis of hedge fund strategies

Government-initiated reforms of the German financial system two decades ago shifted corporate control activities from universal banks to capital markets. Hedge funds took advantage of these changes by acquiring stakes in weakly governed firms. For 653 hedge fund interventions between 2000 and 2020, this study analyzes the changes in financial and operating performance and firm characteristics before and after the event. We also assess the probabilities that a firm becomes a target and that an attack creates shareholders value. On average, hedge funds increased returns, with the magnitude depending on the period, level of aggressiveness, institutional ownership, and industry. Crisis and non-crisis results differ, as hedge funds strategies are mostly successful in a rising stock market environment. Typically, hedge funds targeted smaller and more visible firms with higher sales growth, lower leverage, and higher institutional ownership. After the attack, firm profitability and cash holdings decreased, leverage increased, while investments in M&A and capex declined. This research offers new empirical evidence on the success of hedge fund strategies in Germany and on the performance of targeted firms.     

Caught in the crossfire: How the threat of hedge fund activism affects creditors

Firms under the threat of hedge fund activism on average experience significant losses of outstanding bondholder wealth: their bond yields rise while prices fall and ratings deteriorate. Under-threat firms receive inferior terms when initiating new loans. These observations are more prominent in firms with weaker creditor rights protection and firms that experience more significant improvement in stock performance without accompanying real improvements. These findings are consistent with the manifestation of agency problems. Share repurchases funded by cash, investment cutbacks, and new debt issuances elevate share price, which increases the cost of intervention for activists but jeopardizes the interest of existing bondholders.     

Short-term hedge fund performance

Hedge fund returns are often explained using linear factor models such as Fung and Hsieh (2004). However, since most hedge funds live only for 3 years, these linear regressions are subject to over-parameterization. I improve the out-of-sample accuracy of the linear factor model by combining cross-sectional and time series information for groups of hedge funds with similar investment strategies. The additional cross-sectional information allows more accurate estimates of risk exposures. I also propose a trading strategy based on this methodology for extracting substantially larger risk-adjusted returns.     

The second wave of hedge fund activism: The importance of reputation,clout, and expertise

Using a large dataset of hand-collected information on activist interventions from 2008 to 2014, we examine why certain hedge funds succeed in the face of competition. We document that the top hedge funds succeed, not merely because of how they select targets, but because they acquire a reputation for what we label “clout and expertise.” These hedge funds do not intervene more frequently; to the contrary, activists with more interventions are associated with lower returns. Instead, top activists have a demonstrated ability to succeed in difficult interventions by targeting large firms, launching successful proxy fights, filing and winning lawsuits, pressuring target boards through the media, overcoming anti-takeover defenses, and replacing board members. These activists' successes appear to result more from board representation, improved performance, and monitoring management than from capital structure or dividend policy changes.     

Political influence in hedge fund activism: Causal evidence from U.S. gubernatorial election

This study examines the causal impacts of political influence on hedge fund activism in an exogenous setting of U.S. gubernatorial election. Local incumbent politicians have incentives to protect local inefficient firms from being targeted by activists because activism could lead to divestment and local worker layoffs. And such incentives can become weaker in election years because political competition increases the incumbent politician’s accountability to broader groups of stakeholders. Consistent with this prediction, the likelihood of local firms being targeted by activists is shown to be significantly higher during election years. Moreover, the firm’s political connections mitigate the effects of election, suggesting that politicians still maintain protection to connected firms. Further cross-sectional tests show that the effects of election are stronger (1) for firms with lower labor intensity, severer problem of free cash flow and lower efficiency, and (2) when the political competition is fiercer. Additional tests reveal that hedge fund activism enhances the target firm’s operating performance and creates larger value for investors when it faces weaker political influence. To sum up, our findings suggest that political influence affects hedge fund activism and the activists strategically adjust the timing of initiating campaigns according to the changes of such influence.     

Macroeconomic risk and hedge fund returns

This paper estimates hedge fund and mutual fund exposure to newly proposed measures of macroeconomic risk that are interpreted as measures of economic uncertainty. We find that the resulting uncertainty betas explain a significant proportion of the cross-sectional dispersion in hedge fund returns. However, the same is not true for mutual funds, for which there is no significant relationship. After controlling for a large set of fund characteristics and risk factors, the positive relation between uncertainty betas and future hedge fund returns remains economically and statistically significant. Hence, we argue that macroeconomic risk is a powerful determinant of cross-sectional differences in hedge fund returns.     

Hedge fund activism and trade credit

This study shows that trade creditors extend a negative response to hedge fund activism. Relative to control firms, target firms' accounts payable decrease by 28%, post activist intervention by hedge funds. This reduction is due to supply-side factors, highlighting suppliers' expropriation concerns. The study provides novel evidence that the repercussions of hedge fund activism extend beyond the formal debtholders, and informal debtholders such as trade creditors are not an exception. Further, target firms also offer lower trade credit to their customers after hedge fund activism. Trade receivables decrease by 12% relative to control firms. Activism-induced changes in cash flows potentially account for this reduction in trade receivables.     

Predicting hedge fund performance when fund returns are skewed

We show that fund-specific return skewness is associated with managerial skill and future hedge fund performance. Specifically, skewness in fund returns reflects managerial skill in avoiding large drawdowns. Using a new measure of investment skill that accounts for this managerial ability, we demonstrate that traditional performance measures underestimate (overestimate) managerial performance when returns exhibit positive (negative) fund-specific skewness. Our new measure is particularly valuable during periods of economic crisis, when the annual risk-adjusted outperformance is 5.5%.     

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.     

The financial crisis and hedge fund returns

The financial crisis has focused the lens of politicians and regulators on hedge funds as a source of systemic and operational risk in asset markets. We examine the extent to which available data can provide useful information regarding the impact of hedge funds on the financial system. Using data from January 1994 through September 2008, we find dramatic changes in the exposures of hedge funds to risk factors, accompanied by a significant and widespread increase in correlation between hedge fund and factor returns. Lastly, the discontinuity at zero in the cross-sectional distribution of hedge fund returns persists throughout the sample.     

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.     

The alpha and omega of fund of hedge fund added value

In spite of a somewhat disappointing performance throughout the crisis, investors are showing interest in hedge funds. Still, funds of hedge funds keep on experiencing outflows. Can this phenomenon be explained by the failure of fund of hedge fund managers to deliver on their promise to add value through active management, or is it symptomatic of a move toward greater disintermediation in the hedge fund industry? We introduce a return-based attribution model allowing for a full decomposition of fund of hedge fund performance. The results of our empirical study suggest that funds of hedge funds are funds of funds like others. Strategic allocation turns out to be a crucial step in the investment process, in that it not only adds value over the long-term, but most importantly, it brings resilience precisely when investors need it the most. Fund picking, on the other hand, turns out to be a double-edged sword.     

Exploring uncharted territories of the hedge fund Industry: Empirical characteristics of mega hedge fund firms

This paper investigates mega hedge fund management companies that collectively manage over 50% of the industry's assets, incorporating previously unavailable data from those that do not report to commercial databases. We find similarities among mega firms that report performance to commercial databases compared with those that do not. We show that the largest divergences between the performance of reporting and nonreporting mega firms can be traced to differential exposure to credit markets. Thus, the performance of hard-to-observe mega firms can be inferred from observable data. This conclusion is robust to delisting bias and the presence of serially correlated returns.     

Relative importance of hedge fund characteristics

This study compares the relative importance of thirteen attributes in explaining the cross-sectional variations in the returns of hedge funds, using a large sample from the TASS database covering the 1989–2005 period. We use a simple characteristic-based model of return decomposition, which has never before been applied to hedge funds. The characteristic factors are estimated using cross-sectional dummy-variable regressions. Their importance is found to be time-varying. We find that diversification across styles matters, but that it could be improved significantly by also diversifying across other characteristics, mainly including performance, volatility and fee structure.      

Quantile regression analysis of hedge fund strategies

Extending previous work on hedge fund pricing, this paper introduces the idea of modelling the conditional quantiles of hedge fund returns using a set of risk factors. Quantile regression analysis provides a way of understanding how the relationship between hedge fund returns and risk factors changes across the distribution of conditional returns. We propose a Bayesian approach to model comparison which provides posterior probabilities for different risk factor models that can be used for model averaging. The most relevant risk factors are identified for different quantiles and compared with those obtained for the conditional expectation model. We find differences in factor effects across quantiles of returns, which suggest that the standard conditional mean regression method may not be adequate for uncovering the risk-return characteristics of hedge funds. We explore potential economic impacts of our approach by analysing hedge fund single strategy return series and by constructing style portfolios.     

Optimal hedge fund portfolios under liquidation risk

We use an expected utility framework to integrate the liquidation risk of hedge funds into portfolio allocation problems. The introduction of realistic investment constraints complicates the determination of the optimal solution, which is solved using a genetic algorithm that mimics the mechanism of natural evolution. We analyse the impact of the liquidation risk, of the investment constraints and of the agent's degree of risk aversion on the optimal allocation and on the optimal certainty equivalent of hedge fund portfolios. We observe, in particular, that the portfolio weights and their performance are significantly affected by liquidation risk. Finally, tight portfolio constraints can only provide limited protection against liquidation risk. This approach is of special interest to fund of hedge fund managers who wish to include the hedge fund liquidation risk in their portfolio optimization scheme.     

The dynamics of hedge fund share restrictions

Nearly one in five hedge funds change their share restrictions (e.g., lockup) from 2007 to 2012. Using a large panel dataset, this paper is the first to empirically examine the incidence, determinants, and consequences of share restriction changes. We find that funds with high asset liquidity and low liquidity risk are more likely to decrease share restrictions and funds with good performance are more likely to increase share restrictions. A hazard model indicates that funds who actively manage liquidity concerns live longer by adjusting share restrictions. We examine whether changes in share restrictions create an endogeneity bias in the share illiquidity premium (Aragon, 2007) and find that 18% of the premium can be explained by the dynamic nature of contract changes.     

The performance of female hedge fund managers

Using data for the period 1994–2013, we examine the return and risk-taking behavior of hedge funds having at least one female portfolio manager and funds that have all female portfolio managers. Funds with all female managers perform no differently than all male-managed funds and have similar risk profiles. For single-style funds, those with mixed teams of both genders underperform male-only funds on both a raw and risk-adjusted basis, although mixed funds incur less risk and their Sharpe ratios do not differ. For funds of funds, both all-female and mixed funds have similar performance to male-managed funds. We then consider the failure rate across all fund styles. Funds with at least one female manager fail at higher rates, driven by difficulty in raising capital—these funds are smaller and are less likely to be closed to new investment. Surviving funds with at least one female manager have better performance than male-managed surviving funds, consistent with the idea that female managers need to perform better for their funds to survive. Yet, female-managed surviving funds have fewer assets under management than surviving male-managed funds. Using media mentions as a proxy for investor interest, female-managed funds receive proportionately less attention. Our results suggest that there are no inherent differences in skill between female and male managers, but that only the best performing female managers manage to survive.     

Forecasting the performance of hedge fund styles

This article predicts the relative performance of hedge fund investment styles using time-varying conditional stochastic dominance tests. These tests allow for the construction of dynamic trading strategies based on nonparametric density forecasts of hedge fund returns. During the recent financial turmoil, our tests predict a superior performance for the Global Macro investment style compared with the other strategies of ‘Directional Traders’. The Dedicated Short Bias investment style is stochastically dominated by the other directional styles. These results are confirmed by simple nonparametric tests constructed from realized excess returns. Further, by utilizing a cross-validation method for optimal bandwidth parameter selection, we discover the factors that have predictive power regarding the density of hedge fund returns. We observe that different factors have forecasting power for different regions of the returns distribution and, more importantly, that the Fung and Hsieh factors have power not only for describing the risk premium but also, if appropriately exploited, for density forecasting.