Secrecy and Suspicion
The increasing importance of hedge funds in the market has attracted attention, especially since they've become every politicians' favorite target when discussions move to market stability and manipulation. The secrecy associated with their activities arouses both mystique and suspicion.
New research suggests that this secrecy is important to hedge fund outperformance and, counterintuitively, argues that the attempts to maintain that secrecy are partially responsible for the outperformance. It also does nothing to quench the concerns that covert manipulation by fund managers is occurring, at the cost of obscuring real market signals. So, are we being trimmed by the hedgies?
The term “hedge” suggests that hedge funds are in the business of reducing risk by hedging their investments. In general this is a historical term and modern hedge funds are anything but lower risk as they engage in a variety of proprietary and speculative strategies in an attempt to outperform the market. Mostly, hedge funds are private investment partnerships offering exclusive access to a limited number of wealthy individuals and, as such, are unregulated vehicles for sophisticated investors. It’s a vast oversimplification but you can think of them as mutual funds for very wealthy people.
The unregulated nature of the hedge funds is part of their attraction for investors but has garnered lots of attention over the past few years as various funds have run into problems, got themselves embroiled in insider trading situations and have generally been associated with increasing market instability. Because of this various attempts to regulate them have been introduced, including provisions in the 2010 Dodd-Frank Act and the 2010 EU Alternative Investment Fund Manager Directive, although there’s actually little evidence that hedge funds are strongly implicated in any of the market turmoil of the past decade or so.
The fee structure of hedge funds has been frequently commented on – commonly a management fee of 2% and a performance fee of 20% of profits. This has been criticised in many circles. The UK’s Terry Smith puts it like this:
“As you are aware, Warren Buffett has produced a stellar investment performance over the past 45 years, compounding returns at 20.46 per cent per annum. If you had invested $1,000 in the shares of Berkshire Hathaway when Buffett began running it in 1965, by the end of 2009 your investment would have been worth $4.8m.
However, if instead of running Berkshire Hathaway as a company in which he co-invests with you, Buffett had set it up as a hedge fund and charged 2 per cent of the value of the funds as an annual fee plus 20 per cent of any gains, of that $4.8m, $4.4m would belong to him as manager and only $400,000 would belong to you, the investor. And this is the result you would get if your hedge fund manager had equalled Warren Buffett’s performance. Believe me, he or she won’t.”
In fact the research on whether hedge funds actually outperform in general is mixed, although Kee-Hong Bae, Bok Baik and Jin Mo-Kim in their paper Do Hedge Funds Have Informational Advantages? reckons that they do:
“An arbitrage portfolio that buys and sells stocks in the top and bottom quintiles of the changes in hedge funds’ holdings generates a statistically significant 6.4% excess return per year. We also find that the stocks that hedge funds buy earn higher abnormal returns around subsequent earnings announcements than those that they sell.”
The researchers put the outperformance down to the closed-end structure of hedge funds. Previous research has shown that outperforming mutual funds attract more and more funds, based on investors analysing past returns. As mutual funds are open ended they have to accept this money and eventually run into the Law of Big Numbers where their highly adept managers can no longer deploy the money to outperform the market. Hedge funds don’t have this open ended problem, and can cap the amount of investment funds.
Moreover outperforming managers have an incentive to encourage a low level of investor turnover, because insiders are less likely to share the proprietary secrets that are allowing them to extract these excess profits from the market. So, oddly, the closed end structure of hedge funds enforces the secrecy for which they’re renowned and seems to directly lead to the ability to outperform.
Now this opens up the question of what the “informational advantages” are that allows hedge fund managers to generate abnormal returns. Leaping to the obvious answer that this is some form of insider information isn’t necessarily accurate – if a management team manages to develop a capability to exploit market anomalies and can keep this secret then they can generate such returns in a perfectly straightforward way. Nonetheless a number of studies have started to shine a spotlight on this exact issue.
In Do Hedge Funds Manipulate Stocks?, Itzhak Ben-David, Francesco Franzoni, Augustin Landier and Rabih Moussawi have looked at the end of month behavior of stocks commonly held by hedge funds and have detected some very odd movements:
“Stocks in the top quartile by hedge fund holdings exhibit abnormal returns of 30 basis points in the last day of the month and a reversal of 25 basis points in the following day. Using intraday data, we show that a significant part of the return is earned during the last minutes of the last day of the month, at an increasing rate towards the closing bell. This evidence is consistent with hedge funds’ incentive to inflate their monthly performance by buying stocks that they hold in their portfolios.”
All of which is consistent with funds with a limited amount of capital to deploy waiting until the last moment to manipulate prices – the point being, of course, that fees are determined by end-of-month returns. This seems to be reinforced by the finding that these movements occur when the funds in question have the most incentive to make them happen. This joins previous research by showing similar strange behaviors in stocks held by mutual funds at the end of reporting quarters and around option strike dates.
Moreover, Rui Da, Nadia Massoud, Debarshi Nadny and Anthony Saunders identify possible use of insider information in hedge fund dealings around M&A situations. In Hedge Funds in M&A Deals: Is There Exploitation of Private Information? they conclude: yes, there is. In particular they show that funds specialising in short-term holdings suddenly start taking longer-term positions in the quarter prior to a deal being announced:
“Our results are consistent with the view that short-term hedge funds are able to obtain material non-public information concerning takeover deals prior to the public announcement of such deals. These hedge funds then exploit their informational advantage by taking simultaneous positions in targets (long on the target shares) and their corresponding acquires (shorting the acquires shares) prior to the public M&A announcement date.”
Of course, exploiting informational advantages is a trend that’s as old as markets themselves. Nonetheless, the ability of investment vehicles largely available only to the super-rich to make superior returns simply adds to the weight of evidence that markets are rigged against the private investor. Unlike mutual funds the secrecy and closed-end structure of the funds ensures that the managements can maintain outperformance for significant periods of time and, of course, can keep on generating those all important fees.
Nice work if you can get it. Sadly the rest of us are seeing our returns trimmed by these activities, although doubtless someone is tracking hedge fund activities in order to exploit the information being leaked through their behavior. Although it’s probably another hedge fund.
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