The Economics and Finance of Hedge Funds

Vikas Agarwal is Professor of Finance at Georgia State University. This post is based on an article authored by Professor Agarwal; Kevin Mullally, Doctoral Candidate at Georgia State University; and Narayan Naik, Professor of Finance at London Business School. Related research from the Program on Corporate Governance includes The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here), and The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here).

Critics of hedge funds often label hedge funds as greedy, corrupt, and highly compensated villains who disrupt and pose a threat to financial markets and force corporations to change to policies that destroy firm value. Proponents of hedge funds view them as informed traders who improve market quality and corporate governance. Despite these opposing views, the hedge fund industry has continued to grow at an astounding pace. According to an estimate by Hedge Fund Research, Inc. (HFR) assets in the industry increased from $39 billion in 1990 to about $3 trillion in 2015. Moreover, hedge funds now own a larger fraction of the US stock market with percentage ownership increasing from 3% in 2000‒2003 to 9% during 2008‒2012.

In our paper, The Economics and Finance of Hedge Funds: A Review of the Academic Literature, which was recently published in Foundations and Trends in Finance, we provide a comprehensive survey of the academic literature focused on the hedge fund industry. Although data on hedge funds is still relatively limited when compared to other investment vehicles such as mutual funds, researchers have managed to study a number of topics related to this industry.

Specifically, our paper covers the following topics:

  • Hedge fund performance—Do hedge funds outperform mutual funds and other asset classes? What factors explain hedge funds’ returns? Do hedge fund managers possess skill and, if so, what are the sources of this skill? Finally, are there any benefits to investing in funds of hedge funds? The academic literature, in general, has found that hedge funds tend to outperform mutual funds even after accounting for the higher fees charged by hedge funds. Interestingly, despite the fact that the average hedge fund generates positive alpha, the evidence on performance persistence is mixed. Researchers have also uncovered some potential sources of hedge fund managers’ skill. Specifically, managers have been shown to possess superior security selection ability and time their exposures to certain risk factors (such as market volatility and liquidity risk). Finally, although the consensus is that funds of hedge funds do not perform well enough to justify their additional fees, studies have found that funds of funds help investors access funds closed to new investment and also fire managers who underperform.
  • Hedge fund characteristics and performance—Are there any fund or managerial characteristics that are associated with superior performance? Do compensation incentives impact fund performance? As discussed above, research has uncovered investment flexibility and incentives to be the main sources of hedge funds’ outperformance relative to mutual funds. Funds with higher-powered compensation incentives and funds with more flexibility have been shown to outperform other funds. Younger funds, smaller funds, managers that attended better undergraduate institutions, and funds with more distinct strategies have also been shown to outperform their peers.
  • Hedge fund risk taking and risk management—Does the compensation structure of hedge funds induce greater risk taking? How much operational risk and/or agency problems do hedge fund investors face? Are there ways to predict fraud based on hedge funds’ self-reported returns? How does the use of prime brokers and leverage impact the funding liquidity risk in hedge funds? Are hedge fund investors exposed to liquidity and tail risk? What are the risk management practices of the hedge fund industry and are they effective? Academics have largely concluded that, although hedge funds’ compensation structures are convex, other factors such as managers’ horizons and career concerns mitigate excess risk-taking. Researchers have also uncovered certain patterns in funds’ returns that are correlated with fraud and misreporting.
  • The role of hedge funds in the financial system—Did hedge funds cause the 2008 financial crisis? Do hedge funds propagate systemic risk? Do hedge funds help impound information into stock prices? Does hedge funds’ ability to invest in illiquid assets improve market liquidity? What impacts do activist hedge funds have on corporate policies and corporate governance? In short, a few studies provide evidence that hedge funds caused the financial crisis. Although some studies suggest that hedge funds can manipulate stock prices, the academic literature generally finds that hedge funds help financial markets by providing liquidity and improving price efficiency. Moreover, the literature overwhelmingly suggests that activist hedge funds do not cause corporations to become myopic or employ value-destroying policies.
  • Hedge fund database biases—What are the challenges associated with evaluating hedge fund performance given that our sole source of return data is from commercial databases that rely on voluntary reporting by hedge funds? How accurate is such data—do hedge funds revise or delay their reporting? Are the databases free of survivorship bias? Do hedge funds strategically report to these databases after periods of superior performance? The literature has documented significant issues with these databases; survivorship and selection biases appear to make a significant difference on estimation of hedge funds’ performance.

The full paper is available for download here.

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