Hostname: page-component-7479d7b7d-jwnkl Total loading time: 0 Render date: 2024-07-14T19:52:20.820Z Has data issue: false hasContentIssue false
  • English
  • Français

The Effect of Investment Constraints on Hedge Fund Investor Returns

Published online by Cambridge University Press:  08 October 2018

Juha Joenväärä ,
Robert Kosowski Open the ORCID record for Robert Kosowski [Opens in a new window]  and
Pekka Tolonen
Get access Rights & Permissions [Opens in a new window]

Abstract

This paper examines the effect of real-world, investor-level investment constraints, including several that have not been studied before, on hedge fund performance and its persistence. Using a large consolidated database, we demonstrate that hedge fund performance persistence is significantly reduced when rebalancing rules reflect fund size restrictions and liquidity constraints but remains statistically significant at higher rebalancing frequencies. Hypothetical investor portfolios that incorporate additional minimum diversification constraints, minimum investment requirements, and focus on open funds suggest that the performance and its persistence documented in earlier studies of hedge funds is not easily exploitable, especially by large investors.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 54 , Issue 4 , August 2019 , pp. 1539 - 1571
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2018 

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

Footnotes

1

We thank Vikas Agarwal, Adam Aiken (the referee), Michael Brandt, Jennifer Conrad (the editor), Magnus Dahlqvist, Georges Hübner, Petri Jylhä, Mikko Kauppila, Niklas Kohl, Florencio Lopez-de-Silanes, Andrew Patton, Tarun Ramadorai, and seminar participants at the 2014 Annual Hedge Fund Research Conference in Paris, the 2013 Conference on Advances in the Analysis of Hedge Fund Strategies, the 2013 Norges Bank Investment Management Financial Research Conference, the EDHEC Business School, the Stockholm School of Economics, and the 2013 Young Scholars Nordic Finance Workshop for helpful comments. We are grateful for the support of OP Group Research Foundation.

References

Agarwal, V.; Daniel, N. D.; and Naik, N. Y.. “Role of Managerial Incentives and Discretion in Hedge Fund Performance.” Journal of Finance, 64 (2009), 2221–2256.Google Scholar
Agarwal, V.; Green, T. C.; and Ren, H.. “Alpha or Beta in the Eye of the Beholder: What Drives Hedge Fund Flows?” Journal of Financial Economics, 127 (2018), 417–434.Google Scholar
Agarwal, V., and Naik, N. Y.. “Multi-Period Performance Persistence Analysis of Hedge Funds.” Journal of Financial and Quantitative Analysis, 35 (2000), 327–342.Google Scholar
Aiken, A. L.; Clifford, C. P.; and Ellis, J. A.. “Hedge Funds and Discretionary Liquidity Restrictions.” Journal of Financial Economics, 116 (2015a), 197–218.Google Scholar
Aiken, A. L.; Clifford, C. P.; and Ellis, J. A.. “The Value of Funds of Hedge Funds: Evidence from Their Holdings.” Management Science, 61 (2015b), 2415–2429.Google Scholar
Aiken, A. L.; Clifford, C. P.; Ellis, J. A.; and Huang, Q.. “Funding Liquidity Risk and the Dynamics of Hedge Fund Lockups.” Working Paper, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2848392 (2016).Google Scholar
Almazan, A.; Brown, K. C.; Carlson, M.; and Chapman, D.. “Why Constrain Your Mutual Fund Manager?” Journal of Financial Economics, 73 (2004), 289–321.Google Scholar
Ang, A.; Papanikolaou, D.; and Westerfield, M. M.. “Portfolio Choice with Illiquid Assets.” Management Science, 60 (2014), 2737–2761.Google Scholar
Aragon, G. O.“Share Restrictions and Asset Pricing: Evidence from the Hedge Fund Industry.” Journal of Financial Economics, 83 (2007), 33–58.Google Scholar
Avramov, D.; Kosowski, R.; Naik, N. Y.; and Teo, M.. “Hedge Funds, Managerial Skill, and Macroeconomic Variables.” Journal of Financial Economics, 99 (2011), 672–692.Google Scholar
Baquero, G.; ter Horst, J.; and Verbeek, M.. “Survival, Look-Ahead Bias, and the Persistence in Hedge Fund Performance.” Journal of Financial and Quantitative Analysis, 40 (2005), 493–518.Google Scholar
Berk, J. B., and Green, R. C.. “Mutual Fund Flows and Performance in Rational Markets.” Journal of Political Economy, 112 (2004), 1269–1295.Google Scholar
Bollen, N. P. B.; Joenväärä, J.; and Kauppila, M.. “Picking Winners? Selecting Hedge Funds for a Diversified Portfolio.” Working Paper, Vanderbilt University and University of Oulu (2019).Google Scholar
Bollen, N. P. B., and Pool, V. K.. “Suspicious Patterns in Hedge Fund Returns and the Risk of Fraud.” Review of Financial Studies, 25 (2012), 2673–2702.Google Scholar
Boyson, N. M.“Hedge Fund Performance Persistence: A New Approach.” Financial Analyst Journal, 64 (2008), 27–44.Google Scholar
Braithwaite, T.“CalPERS Pulls Out of ‘Costly’ Hedge Funds.” Financial Times https://www.ft.com/content/eb1cfd56-3d26-11e4-871d-00144feabdc0 (2014).Google Scholar
Brown, S. J.; Fraser, T. L.; and Liang, B.. “Hedge Fund Due Diligence: A Source of Alpha in a Hedge Fund Portfolio Strategy.” Journal of Investment Management, 6 (2008), 23–33.Google Scholar
Brown, S. J.; Goetzmann, W.; and Ibbotson, R.. “Offshore Hedge Funds: Survival and Performance 1989–95.” Journal of Business, 72 (1999), 91–117.Google Scholar
Brown, S. J.; Goetzmann, W.; Liang, B.; and Schwarz, C.. “Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration.” Journal of Finance, 63 (2008), 2785–2815.Google Scholar
Brown, S. J.; Goetzmann, W.; Liang, B.; and Schwarz, C.. “Estimating Operational Risk for Hedge Funds: The 𝜔-Score.” Financial Analysts Journal, 65 (2009), 43–53.Google Scholar
Brown, S. J.; Goetzmann, W.; Liang, B.; and Schwarz, C.. “Trust and Delegation.” Journal of Financial Economics, 103 (2012), 221–234.Google Scholar
Diamond, D. W., and Verrecchia, R. E.. “Constraints on Short-Selling and Asset Price Adjustment to Private Information.” Journal of Financial Economics, 18 (1987), 277–311.Google Scholar
Drechsler, I., and Drechsler, Q. F. S.. “The Shorting Premium and Asset Pricing Anomalies.” Working Paper, New York University and University of Pennsylvania (2014).Google Scholar
Edelman, D.; Fung, W.; and Hsieh, D. A.. “Exploring Uncharted Territories of the Hedge Fund Industry: Empirical Characteristics of Mega Hedge Fund Firms.” Journal of Financial Economics, 109 (2013), 734–758.Google Scholar
Figlewski, S.“The Informational Effects of Restrictions on Short Sales: Some Empirical Evidence.” Journal of Financial and Quantitative Analysis, 16 (1981), 463–476.Google Scholar
Fung, W., and Hsieh, D.. “Performance Characteristics of Hedge Funds and Commodity Funds: Natural versus Spurious Biases.” Journal of Financial and Quantitative Analysis, 35 (2000), 291–307.Google Scholar
Fung, W., and Hsieh, D.. “Hedge Fund Benchmarks: A Risk-Based Approach.” Financial Analysts Journal, 60 (2004), 65–70.Google Scholar
Fung, W., and Hsieh, D.. “Measurement Biases in Hedge Fund Performance Data: An Update.” Financial Analysts Journal, 65 (2009), 36–40.Google Scholar
Ganshaw, T. Hedge Funds Humbled: The 7 Mistakes that Brought Hedge Funds to Their Knees and How They Will Rise Again. New York, NY: McGraw-Hill Professional (2010).Google Scholar
Hombert, J., and Thesmar, D.. “Overcoming Limits of Arbitrage: Theory and Evidence.” Journal of Financial Economics, 111 (2014), 26–44.Google Scholar
Jagannathan, R.; Malakhov, A.; and Novikov, D.. “Do Hot Hands Exist among Hedge Fund Managers? An Empirical Evaluation.” Journal of Finance, 65 (2010), 217–255.Google Scholar
Joenväärä, J.; Kauppila, M.; Kosowski, R.; and Tolonen, P.. “Hedge Fund Performance: Are Stylized Facts Sensitive to Which Database One Uses?” Critical Finance Review, forthcoming (2019).Google Scholar
Kosowski, R.; Naik, N. Y.; and Teo, M.. “Do Hedge Funds Deliver Alpha? A Bayesian and Bootstrap Analysis.” Journal of Financial Economics, 84 (2007), 229–264.Google Scholar
Kosowski, R.; Timmermann, A.; Wermers, R.; and White, H.. “Can Mutual Fund ‘Stars’ Really Pick Stocks? New Evidence from a Bootstrap Analysis.” Journal of Finance, 61 (2006), 2551–2595.Google Scholar
“Launch Bad: Breaking into the Hedge-Fund World Is Harder than Before.” Economist https://www.economist.com/finance-and-economics/2013/04/20/launch-bad (2013).Google Scholar
Liang, B.“On the Performance of Hedge Funds.” Financial Analysts Journal, 55 (1999), 72–85.Google Scholar
Liang, B.“Hedge Funds: The Living and the Dead.” Journal of Financial and Quantitative Analysis, 35 (2000), 309–325.Google Scholar
Liu, X., and Mello, A. S.. “The Fragile Capital Structure of Hedge Funds and the Limits to Arbitrage.” Journal of Financial Economics, 102 (2011), 491–506.Google Scholar
Luttmer, E. G. J.“Asset Pricing in Economies with Frictions.” Econometrica, 64 (1996), 1439–1467.Google Scholar
Malkiel, B. G., and Saha, A.. “Hedge Funds: Risk and Return.” Financial Analysts Journal, 61 (2005), 80–88.Google Scholar
Mackintosh, J.“Transformed Hedge Funds in Calmer Water.” Financial Times https://www.ft.com/content/98cd1ee4-cf92-11e2-a050-00144feab7de (2013).Google Scholar
Novy-Marx, R., and Velikov, M.. “A Taxonomy of Anomalies and Their Trading Costs.” Review of Financial Studies, 29 (2015), 104–147.Google Scholar
Pastor, L., and Stambaugh, R.. “Liquidity Risk and Expected Stock Returns.” Journal of Political Economy, 111 (2003), 642–685.Google Scholar
Pastor, L., and Stambaugh, R.. “On the Size of the Active Management Industry.” Journal of Political Economy, 120 (2012), 740–781.Google Scholar
Patton, A. J., and Timmermann, A.. “Monotonicity in Asset Returns: New Tests with Applications to the Term Structure, the CAPM, and Portfolios Sorts.” Journal of Financial Economics, 98 (2010), 605–625.Google Scholar
Ramadorai, T.“Capacity Constraints, Investor Information, and Hedge Fund Returns.” Journal of Financial Economics, 107 (2013), 401–416.Google Scholar
Sun, Z.; Wang, A.; and Zheng, L.. “The Road Less Traveled: Strategy Distinctiveness and Hedge Fund Performance.” Review of Financial Studies, 25 (2012), 96–143.Google Scholar
Teo, M.“Does Size Matter in the Hedge Fund Industry?” Working Paper, Singapore Management University (2010).Google Scholar
Titman, S., and Tiu, C.. “Do the Best Hedge Funds Hedge?” Review of Financial Studies, 24 (2011), 123–168.Google Scholar
Supplementary material: File

Joenväärä et al. supplementary material

Joenväärä et al. supplementary material 1

Download Joenväärä et al. supplementary material(File)
File 1.2 MB