The Long and the Short of it: Evidence of Year-End Price Manipulation by Short Sellers
Researchers: Jesse Blocher (University of North Carolina, Chapel Hill), Joseph Engelberg (University of North Carolina, Chapel Hill), and Adam V. Reed (University of North Carolina, Chapel Hill)
We identify a setting in which there is a predictable incentive for short sellers to manipulate prices, and we find patterns consistent with short sellers manipulating prices. Specifically, we find that stocks with high short interest experience abnormally low returns on the last trading day of the year. This effect is strongest among stocks that are easily manipulated and during the last hour of trading. Further, this effect reverses at the beginning of the year, consistent with the temporary nature of price manipulation. We show that hedge funds’ portfolios are closely related to market-wide short interest, suggesting that hedge funds, with their convex compensation structures, may generate the patterns we observe. In additional analysis, we find that larger price effects are associated with higher idiosyncratic volatility, offering a potential explanation for why temporary price effects are allowed to persist in the presence of rational arbitrageurs, but we find no evidence to suggest that extended non-trading-day holding periods play a role in the magnitude of the effects. Finally, we provide evidence of mutual funds and short sellers avoiding each other, and we show that downward pressure by short sellers is outweighed by upward pressure by buyers. In other words, since short sellers’ incentives are mirrored by buyers’ incentives in the opposite direction, our experiment provides evidence that short sellers manipulate prices in much the same way buyers do, and manipulation by short sellers is no stronger than manipulation by buyers.
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Inferring Reporting-Related Biases in Hedge Fund Databases from Hedge Fund Equity Holdings
Researchers: Vikas Agarwal (Georgia State University), Vyacheslav Fos (Columbia University), Wei Jiang (Columbia University)
This paper formally analyzes the biases related to self-reporting in the hedge funds databases by matching the quarterly equity holdings of a complete list of 13F-filing hedge fund companies to the union of five major commercial databases of self-reporting hedge funds between 1980 and 2008. Conditional on self-reporting, we find significant evidence of a timing bias in both reporting initiation and termination (delisting): Funds initiate self-reporting after positive abnormal returns which do not persist into the reporting period; while termination of self-reporting is followed by both return deterioration and outflows from the funds. Unconditionally, the propensity to self-report is consistent with the trade-offs between the benefits (e.g., access to prospective investors) and costs (e.g., partial loss of trading secrecy and flexibility in selective marketing). Finally, self-reporting and non-reporting funds do not differ significantly in return performance, reflecting the offsetting factors motivating self-reporting.
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Side-by-side Management of Hedge Funds and Mutual Funds
Researchers: Tom Nohel (Loyola University), Z. Jay Wang (University of Illinois), and Lu Zheng (University of California, Irvine)
Forthcoming in the Review of Financial Studies
We examine situations where the same fund manager simultaneously manages mutual funds and hedge funds. We refer to this as side-by-side management. We document 344 such cases involving 693 mutual funds and 538 hedge funds. Proponents of this practice argue that it is essential to hire and retain star performers. Detractors argue that the temptation for abuse is high and the practice should be banned. Our analysis based on various performance metrics shows that side-by-side mutual fund managers significantly outperform peer funds, consistent with this privilege being granted primarily to star performers. Interestingly, side-by-side hedge fund managers are at best on par with their style category peers, casting further doubt on the idea that conflicts of interest undermine mutual fund investors. Thus, we find no evidence of welfare loss for mutual fund investors due to exploitation of conflicts of interest.
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Can Hedge Funds Time Liquidity?
Researchers: Charles Cao (Pennsylvania State University), Yong Chen (Virginia Tech), and Bing Liang (University of Massachusetts at Amherst), Andrew W. Lo (MIT Sloan School of Management)
This paper examines how hedge funds manage their liquidity risk by responding to the aggregate liquidity shock. Using a large sample of hedge funds over the period of 1994-2008, we find strong evidence that hedge fund managers possess liquidity timing ability at both investment strategy level and the individual fund level. They increase (decrease) their portfolios' market exposure when the equity market liquidity is high (low). More importantly, the liquidity timing evidence is particularly significant among funds with illiquid holdings. In contrast, hedge fund managers who hold liquid assets tend to react to past liquidity conditions strongly. The liquidity timing ability is also asymmetric, depending on market liquidity conditions: it is more pronounced when the market liquidity is low than when it is high. Our results are robust even after we control for return- and volatility-timing abilities.
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The Liquidity Risk of Liquid Hedge Funds
Researcher: Melvyn Teo (Singapore Management University)
Forthcoming in the Journal of Financial Economics
Abstract: This paper evaluates hedge funds that grant favorable redemption terms to investors. Within this group of purportedly liquid funds, high net inflow funds subsequently outperform low net inflow funds by 4.79 percent per year after adjusting for risk. The return impact of fund flows is stronger when funds embrace liquidity risk, when market liquidity is low, and when funding liquidity, as measured by the TED spread, aggregate hedge fund flows, and prime broker stock returns, is tight. In keeping with an agency explanation, funds with strong incentives to raise capital, low manager option deltas, and no manager capital co-invested are more likely to take on excessive liquidity risk. These results resonate with the theory of funding liquidity by Brunnermeier and Pedersen (2009).
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Does Size Matter in the Hedge Fund Industry?
Researcher: Melvyn Teo (Singapore Management University)
We document a negative and convex relationship between hedge fund size and future risk-adjusted returns. Small hedge funds outperform large hedge funds by 2.75 percent per year after adjusting for risk. This over performance cannot be explained by fund age, leverage, serial correlation, backfill bias, or incubation bias. The capacity constraints are not confined to the smallest funds, and manifest across various investment styles and regions. In particular, they are strongest for funds managed by multiple principals that trade small, illiquid securities, suggesting that the observed diseconomies can be traced to price impact and hierarchy costs (Stein, 2002). Interestingly, these capacity constraints facing individual hedge funds do not extend to funds of hedge funds.
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Hedge Funds, Managerial Skill, and Macroeconomic Variables
Researchers: Doron Avramov (University of Maryland), Robert Kosowski (Imperial College), Narayan Y. Naik (London Business School) and Melvyn Teo (Singapore Management University)
Forthcoming in the Journal of Financial Economics
This paper evaluates hedge fund performance through portfolio strategies that incorporate predictability based on macroeconomic variables. Incorporating predictability substantially improves out-of-sample performance for the entire universe of hedge funds as well as for various investment styles. While we also allow for predictability in fund risk loadings and benchmark returns, the major source of investment profitability is predictability in managerial skills. In particular, long-only strategies that incorporate predictability in managerial skills outperform their Fung and Hsieh (2004) benchmarks by over 17 percent per year. The economic value of predictability obtains for different rebalancing horizons and alternative benchmark models. It is also robust to adjustments for backfill bias, incubation bias, illiquidity, fund termination, and style composition.
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Dynamic Investment Opportunities and the Cross-Section of Hedge Fund Returns: Implications of Higher-Moment Risks for Performance
Researchers: Vikas Agarwal (Georgia State University), Gurdip Bakshi (University of Maryland), Joop Huij (RSM Erasmus University)
In this paper, we examine higher-moment market risks in the cross-section of hedge fund returns to make several contributions. First, we show that hedge funds are substantially exposed to the three highermoment risks - volatility, skewness, and kurtosis. In contrast, mutual funds do not display meaningful dispersions in their exposures to these risks. Further, funds of hedge funds when examined as a separate investment category do not show aggressive loading on higher-moment risks. Second, we provide evidence on economically significant premiums being embedded in hedge fund returns on account of their exposures to higher-moment risks. Third, we uncover a set of higher-moment factors that are not strongly associated with factors in benchmark models that are currently used for evaluating hedge fund performance. Finally, the addition of these higher-moment factors to benchmark models can better explain the variation in hedge fund returns. Bearing on issues of practical consequence, we find that benchmark models augmented with higher-moment factors can considerably alter the hedge funds’ alpha-based rankings.
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The Geography of Hedge Funds
Researcher: Melvyn Teo (Singapore Management University)
Forthcoming in the Review of Financial Studies
This paper analyzes the relationship between the risk-adjusted performance of hedge funds and their proximity to investments using data on Asian-focused hedge funds. We find, relative to an augmented Fung and Hsieh (2004) factor model, that hedge funds with a physical presence (head or research office) in their investment region outperform other hedge funds by 3.72 percent per year. The local information advantage is pervasive across all major geographical regions, but is strongest for Emerging Market funds and funds holding illiquid securities. These results are robust to adjustments for fund fees, serial correlation, backfill bias, and incubation bias. We show also that distant funds, especially those based in the U.S. and the U.K., are able to raise more capital, charge higher fees, and set longer redemption periods, despite their underperformance relative to nearby funds. It appears that distant funds trade investment performance for better access to capital.
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Do Hedge Funds Deliver Alpha? A Bayesian and Bootstrap Analysis
Researchers: Robert Kosowski (Imperial College), Narayan Naik (London BusinessSchool) and Melvyn Teo (Singapore Management University)
Published in the Journal of Financial Economics
Using a robust bootstrap procedure, we find that top hedge fund performance cannot be explained by luck, and that hedge fund performance persists at annual horizons. Moreover, we show that Bayesian measures, which help overcome the short-sample problem inherent in hedge fund returns, lead to superior performance predictability. Relative to sorting on OLS alphas, sorting on Bayesian alphas yields a 5.5 percent per year increase in the alpha of the spread between the top and bottom hedge fund deciles. Our results are robust, and relevant to investors, as they are neither confined to small funds, nor driven by incubation bias, backfill bias or serial correlation.
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How dependent are returns across hedge fund investment strategies? We estimate the probability that each investment strategy performs poorly when other investment strategies are delivering extreme negative returns. Under extreme market conditions, we find that event driven, distressed debt, and equity long/short funds exhibit the highest correlation with other styles while commodity trading advisors, macro, and equity market neutral funds exhibit the lowest correlation. In addition, we show that Asia-focused event driven and equity market neutral funds provide diversification for investors holding US- and Europe-focused funds.
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- Asset Gathering by Hedge Fund Firms
We explore agency issues within hedge fund firms. We find that firms that launch many funds tend to underperform other firms by between 3 to 5 percent per year after adjusting for risk. These findings are strongest for firms offering funds that pursue many distinct strategies, invest in a variety of geographical regions, locate in a gamut of countries, and offer different base currencies. Our results allow fund investors to distinguish, ex-ante, firms that focus on delivering alpha from those that focus on gathering assets.
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- Flagship Funds at Hedge Fund Families
Motivated by the stellar performance of flagship funds such as the Renaissance Medallion fund, we ask whether hedge fund firms (e.g., Renaissance Technologies) have incentives to protect the performance of their flagship funds (e.g., Medallion). We find that the flagship fund tends to outperform other funds within the fund family. The fees and redemption terms of non-flagship funds at launch is correlated with the past performance of the flagship fund. Finally, flagship fund performance has a positive impact on net flows into the other funds within the same family.
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- The risk exposures of Asia-focused hedge funds
How have Asia-focused hedge funds adjusted their risk exposures in response to the recent financial crisis? By evaluating fund performance relative to an augmented Fung and Hsieh (2004) model, we find that Asia-focused hedge funds have broadly trimmed risk exposures post-crisis. They have reduced their exposure to small stocks relative to large stocks, scaled back their loadings on high yield corporate bonds relative to low yield U.S. sovereign debt, and pared their allocation to the Japanese equity markets. At the same time, however, they are now more exposed to Asian equity markets.
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- Quantitative Hedge Fund Selection (Part 2)
Do fund incentives, volatility exposure, and liquidity risk affect fund performance? We show that hedge funds with high performance fees and high water mark provisions tend to outperform those with low performance fees and no high water marks. Moreover, funds that short volatility and embrace liquidity risk deliver significantly higher returns relative to funds that long volatility and eschew liquidity risk. Investors with access to secure capital and managed account platforms may be positioned to take advantage of these performance differences.
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- Quantitative Hedge Fund Selection
Prior research has shown that small funds, young funds, and local funds outperform their older, larger, and distant counterparts. According to the literature, hedge fund performance is driven by fund capacity constraints, managerial incentives, and local information. I revisit these studies on hedge funds and test whether their results hold up in recent data. By doing so, I lay the foundations for a quantitative hedge fund selection framework.
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We find that analysts are more likely to issue favorable recommendations for stocks predominantly owned hedge funds. Moreover, these optimistic recommendations translate into poorer stock performance over the next three to six months. Hedge funds take advantage of these flattering reports by concurrently offloading their stock holdings. Our results suggest that analysts are reluctant to downgrade stocks held by their most important clients.
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How has the financial crisis shaped the hedge fund industry in Asia? We survey the style, investment region, and assets under management landscape of Asia-based hedge funds before and after the recent economic downturn. Our findings suggest that during the early part of the crisis in 2007, macro and fixed income funds based in Australia were especially vulnerable. When Asian financial markets succumbed in 2008 and 2009, hedge fund exits ramped up in Singapore and Hong Kong, particularly amongst event driven and Japan-focused funds. Small funds were most susceptible to closure during the liquidity crunch. Conversely, CTAs and Greater China-focused funds appear to have weathered the stormy conditions relatively well.
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Why do correlations all go to one when economic conditions turn bad? We review the latest research on funding liquidity (the ease with which hedge funds obtain capital) and discuss its implications on the asset liquidity and valuations of securities held by funds, on subsequent fund performance, and on contagion across hedge fund investment styles.
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I apply the endogenous benchmark approach to the study of hedge funds. I find that including an investment style benchmark significantly reduces within style correlations in hedge fund residuals. Also, the performance spread between high past alpha t -statistic (a risk-adjusted information ratio) funds and low past alpha t -statistic funds increases dramatically when performance is measured relative to fund investment style. There appears to be valuable information in investment style performance that can aid in fund selection
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We examine two of the most fascinating fraud cases that rocked the hedge fund industry: Bernard L. Madoff Investment Securities and Bayou Management. From academic research and news reports, we distill important lessons for the hedge fund investor. Our key conclusions are (i) conflicts of interests are often symptomatic of more serious problems at hedge funds, (ii) auditing statements from obscure accounting firms should provide little assurance to investors, (iii) a comparison between the actual fund risk exposures based on realized returns with the theoretical risk exposures from the trading strategy serves as a useful cross-check for investors, and (iv) for funds with a master-feeder structure, it is important to conduct due diligence on both the master and the feeder fund.
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Many hedge funds impose minimal share restrictions and allow investors to redeem on a monthly basis or better. We find that there is significant variation in the liquidity risk exposure of these “liquid” funds. Within this group of funds, those that embrace liquidity risk outperform those that eschew liquidity risk by 4.86 percent per year. As a consequence of the liquidity risk exposure, funds experiencing outflows subsequently earn lower returns than funds receiving inflows. The effects of flows are more pronounced for funds employing leverage, for funds with high liquidity risk exposure, and during a liquidity crunch. These results underscore the importance of funding liquidity (the ease with which traders can obtain capital) and shed light on the asset-liability mismatch in the hedge fund industry.
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Market liquidity profoundly impacts hedge funds. Funds trading illiquid securities earns
significant risk premium, report smoother returns, can better leverage on information
asymmetries, and grapple with stronger capacity constraints. Importantly, the funding liquidity of hedge funds, or their ease of obtaining financing, can have a significant effect on the market liquidity of the securities they trade in, creating a downward liquidity spiral during economic downturns. We review the academic literature and deliver insights that resonate with recent market events.
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Statistical Digest
Dec 2008 Issue - How Surprising are Returns in 2008? A Review of Hedge Fund Risks
Many investors, expecting absolute returns, were shocked by the dismal performance of various hedge fund investment strategies in 2008. In this issue of the statistical digest, I review the academic literature on hedge fund risks and conduct some simple analyses. I find that many hedge funds, even those without directional equity exposure, have payoffs that resemble those from writing put options on equity indices. A central theme is that their strategies all involve being short liquidity. Therefore, these hedge funds tend to underperform during liquidity crises, which coincide with extreme bear markets.
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July 2008 Issue - Hedge Funds in a Volatile Market
We show that relative to the first half of 2007, the volatility of hedge fund returns has doubled during the September 2007 to April 2008 period. At the same time, aggregate hedge fund returns have declined while exit rates have tripled. Commodity, macro, and, to a lesser extent, arbitrage funds outperformed during this period, while bottom-up funds underperformed. In Asia, funds engaging in less traditional strategies like arbitrage, event driven, fixed income, and distressed debt have emerged relatively unscathed. Our results also suggest that around the world, funds with headquarters near their investment markets, fewer assets under management, and higher performance fees have weathered the storm better than other funds.
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Nov 2007 Issue - Lessons from the Sub-Prime Crisis
We show that there is significant variation in performance across hedge funds during the subprime crisis. Hedge funds that (i) invested in Asia , (ii) had equity exposure, (iii) adopted directional strategies, or (iv) allowed for frequent redemptions, underperformed other funds. Moreover, leveraged funds did not fare significantly worse than their non-leveraged counterparts. Our results suggest that credit market illiquidity was not directly responsible for the bloodshed amongst hedge funds. Rather, funds were hurt by a global increase in risk aversion and by fire sales conducted in anticipation of redemptions.
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Jul 2007 Issue - Asian Hedge Funds: A Tale of Three Cities
In this issue of the statistical digest, we use a fairly unique lens to view hedge funds: manager location. We uncover differences in size, investment strategies, and investment geography between funds managed from Hong Kong , Singapore , and Sydney . Funds managed from Hong Kong tend to be Equity Long/Short funds between US$100m to US$500m in size. Funds in Singapore tend to be smaller while funds in Sydney demonstrate significant variation in assets under management. Sydney attracts a disproportionate number of CTA funds while Singapore attracts a disproportionate number of Macro and Japan focused funds.
We also show that there are systematic differences in risk exposures between funds managed from the three centres. Asia ex Japan and Asia incl Japan Equity Long/Short funds managed from Sydney tend to have lower market exposures relative to other Asian funds. Similarly, Japan focused Equity Long/Short funds managed from Singapore tend to have a lower exposure to the Nikkei 225 index relative to other Japan focused funds.
Finally, our performance analysis reveals that funds managed from Asia outperform funds managed from the US and the UK . A local informational advantage manifests in Asia and this translates to differences in risk-adjusted returns between nearby and distant fund portfolios of around 2 and 4% per year. While Asian Equity Long/Short funds managed from Hong Kong outperform those managed from Singapore and Sydney , we hypothesize that some of the over performance may be driven by Hong Kong 's geographical proximity to China . These results are relevant to hedge fund investors considering an allocation to Asia .
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