The hedge fund industry’s meteoric explosion from some $38 billion in 1990 to more than $2 trillion in 2012 is as mystifying as the few star managers who control the lion’s share of its wealth. Is it superior trading skills that generate stellar returns that make a star, or do the most successful hedge funds profit by both buying and selling illiquid securities at favorable prices from impatient investors?
Russell E. Jame, Assistant Professor at the University of Kentucky’s Gatton College of Businesss & Economics, says star quality in Hedgeworld boils down to four explanations: shareholder activism, skilled processing of public information, insider trading and liquidity provision.
As they made they’ve made their way into the mainstream, activist hedge funds now manage some $65.5 billion, a more than fivefold jump in a decade.
Carl Icahn, once the dark lord of corporate raiders who inspired the Gordon Gekko character in Wall Street, has become a Twitter celebrity who has redefined the role of activists and set the spotlight on a once secretive world that’s now regarded as a shareholder ally.
Through the end of June, activist funds were up 9.6%, beating the 7.7% gain by equity-focused hedge funds, according to Hedge Fund Research. Activist funds have returned on average nearly 13% between 2009 and last year.
“The fact that star hedge funds’ profits are similar in both growth and value stocks is inconsistent with the view that most star hedge funds profit through activism,” says Jame. “This is not surprising, given that activist hedge funds make up a small fraction of the hedge fund universe.”
Not every hedge fund manager can be an activist. For those with more patience than passion that feeds a PR machine like one driving today’s activists, collecting and processing public information offers a slower, steadier path to stardom.
Says Jame: “processing of public information may accrue over relatively long holding periods. For example, a manager may take positions in stocks that he believes are undervalued and wait several quarters (or several years) until the market eventually agrees with his positions.”
Relying on public information means your fund is likely to be heavily weighted in major firms. Those who invest in smaller firms and ahead of earnings announcements, are likely to make bets based on private information.
Insider trading is a dirty word that isn’t getting a facelift like activism anytime soon. Both strategies are subject to short term holding periods, as activists reap rewards at the announcement of activism and insider trading generally occurs ahead of a public announcement.
There are plenty of ways high frequency traders can legally access information ahead of market moves, and some are legal.
While activists tend to favor value stocks, those focused on liquidity provision strategies tend to embrace contrarian strategies. “Star hedge funds are also net buyers of liquid securities,” notes Jame.
A new study from Preqin found that hedge funds charging more than the industry-standard 20% for performance have been the best performers over the past six years. Those with the highest net-returns on both three- and five-year annualized basis have posted the best risk-adjusted returns.
“I find no significant relationship between management fees and the likelihood of being a star hedge fund trader,” says Jame of his own research.
Preqin’s findings may be linked to the current low-interest-rate environment, and stars can’t cling to a single cycle.
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