2018 was another very poor year for hedge fund investors, with the HFRX Global Hedge Fund Index losing 6.7%. That comes after a decade over which the index underperformed every major global equity index and bond index—losing 0.4% from 2008 through 2017.
Lin Sun and Melvyn Teo contribute to the literature on the performance of hedge funds with their study “Public Hedge Funds,” which appears in the January 2019 issue of the Journal of Financial Economics. The recent public listings by giant hedge fund management ﬁrms (including Amundi, Man Group, Och-Ziff Capital Management Group, The Blackstone Group and KKR & Co.) led them to investigate whether the performance of publicly owned hedge funds differed from the performance of privately owned ones. Specifically, they examined how the performance changed in the post-IPO period.
Sun and Teo noted: “The fund management companies argue that going public allows them to enhance investment performance by better incentivizing their staff through employee stock options and by investing the initial public offering (IPO) proceeds in superior technology and business support.”
They also noted that being public brings more transparency. The counterargument made by fund investors, the authors wrote, is that, “Public listing allows ﬁrm founders to sell off their stakes to outsiders, which exacerbates potential conﬂicts of interest. For asset managers, the transition to public markets weakens the alignment between ownership, control, and investment capital, engendering a rich combination of agency problems.”
One key issue is that post-IPO, the founders of the ﬁrm sell out to new shareholders, who typically do not invest alongside the limited partners. Thus, their focus may not be on performance but on growth of fund assets (and the fees that go with that growth). And with growth comes concerns over diseconomies of scale.
Sun and Teo evaluated hedge funds using monthly net-of-fees returns and assets under management (AUM) data of live and dead hedge funds reported in the TASS, Hedge Fund Research (HFR) and BarclayHedge data sets from January 1994 to December 2013. Their data set included a total of 16,592 hedge funds—5,947 live funds and 10,645 dead funds at the end of the period. Note that there were 80% more dead than live funds at the end of the period, highlighting the poor performance of most hedge funds and the importance of addressing the issue of survivorship bias in the data.
They examined risk-adjusted returns based on the seven Fund and Hsieh factors, which have been found to have strong explanatory power for hedge fund returns (the excess return on the S&P 500 Index; a small minus big factor constructed as the difference between the Russell 2000 and the S&P 500 indexes; the yield spread of the U.S. 10-year Treasury bond over the three-month Treasury bill, adjusted for duration of the 10-year bond; the change in the credit spread of Moody’s BAA bond over the 10-year Treasury bond, also appropriately adjusted for duration of the 10-year bond; and the excess returns on portfolios of lookback straddle options on currencies, commodities and bonds).
Following is a summary of their findings:
- Hedge funds managed by listed companies underperform those managed by unlisted ﬁrms by a statistically significant 1.9% per year (t-statistic = 3.1).
- After adjusting for factor exposures, hedge funds managed by listed ﬁrms underperform hedge funds managed by unlisted ﬁrms by 2.89% per year (t-statistic = 4.7).
- The results are not confined to the smallest funds and cannot be explained by differences in share restrictions, illiquidity or other issues examined.
- The underperformance of funds managed by listed ﬁrms is not peculiar to a particular year.
- Relative to the ﬁve-year pre-IPO period, average fund risk-adjusted performance deteriorates by an annualized 8.40%, and average ﬁrm alpha wanes by an annualized 7.20%. The results are statistically significant at the 1% level.
- Funds that have the greatest scope for asset gathering, as a consequence of their low liquidity risk levels, also exhibit the most severe underperformance.
- Among listed ﬁrms, those with low insider ownership and whose IPO prospectuses reveal that existing shareholders cash out underperform more.
- Despite the poor performance, relative to the control group, public ﬁrms are able to grow their AUM by 78% during the same period. The surge in ﬁrm AUM stems both from organic growth in existing fund AUM and from the launch of new funds post listing—suggesting that the new capital raised goes toward the marketing of existing and new products.
- Firms are more likely to raise additional funds post IPO—listing increases the chance that a ﬁrm will raise a new fund by almost a third.
Sun and Teo concluded: “The results in this paper challenge the view that asset management ﬁrms list to enhance investment performance.” They added: “Our ﬁndings indicate that the process of going public heightens conﬂicts of interest, which are in turn associated with poorer performance”—the drive to increase AUM trumps performance.
Importantly, the authors noted that the underperformance is driven by listed ﬁrms whose existing shareholders cashed out during the IPO: “After adjusting for risk, funds managed by listed ﬁrms in which existing shareholders cashed out underperform funds managed by unlisted ﬁrms by 4.58% per year (t-statistic = 2.86), and those managed by listed ﬁrms in which existing shareholders did not cash out under-perform their unlisted competitors by a modest 0.27% per year (t-statistic = 0.35).”
The hedge fund industry has been destroying returns now for over a decade. To make matters worse, Sun and Teo demonstrate that the conﬂicts of interest at hedge funds managed by listed ﬁrms translates into a tendency to raise capital by growing the AUM of existing and new products—which, in turn, leads to underperformance.
Funds that have the greatest scope for asset gathering, as a consequence of their low liquidity risk levels, exhibit the most severe underperformance. Forewarned is forearmed.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.