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立 政 治 大 學
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DOI:10.6814/NCCU202001043
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3. Know the actively managed funds
Table 3: Hedge funds – “mutual funds on steroid”
The two main branches of actively managed funds are mutual funds and hedge funds. A hedge fund is like “mutual fund on steroid”. Using performance around the merge-arbitrage event, Cao et al. (2016) find hedge funds outperform 3.7% annually than other institutional investors. Unlike mutual funds on average provide no alpha, Ibbotson, Chen, and Zhu (2011) decompose hedge funds returns into alpha 3.0%, beta 4.7%, and fees 3.4%. While control of survivor and backfill biases, they find hedge funds have positive alpha even during the 2009 crisis.
Though private equity and hedge funds are relatively small for the global equity market, both account for less than three percent as Fichtner (2019) mentions. Their customers are high-net-worth individuals and institutional investors, not for average Joe. Thus, the regulatory agencies do not need to protect the public that may be scammed by the fund companies. Compare to the mutual funds, they have practically no regulations and can use all the tricks to maximizing their profit. Including every
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financial instrument, shorting position, high-leverage, and involvement in corporate management. There is one type of mutual finds called “hedge fund for the retail investor” - the long/short funds, the mutual funds can take a short position like hedge funds. McCarthy and Wong (2020) find they still underperform by different hedge fund indexes 1.7% to 3.5% annually.
The managers of hedge funds are also heavily rewarded by their compensation structure. Hedge funds and private equity often on “two and twenty” base. That is low (about 1.5% percent) fees and a high portion (twenty percent) of portfolio value that exceeds a set target, i.e. “high water mark”. Kaplan and Rauh (2010) estimate their fees are between 3.2% to 4.4% AUM, significantly higher than mutual funds.
Consistent with Ibbotson, Chen, and Zhu (2011) 3.4% estimation.
By comparison, both actively managed mutual funds and index mutual funds, their fees are calculated by a percentage of assets under management (AUM), and they are dropping for the last decade. By Investment Company Institute (2019), for actively managed equity mutual funds, expense ratio drops from 0.99% for 2009, to 0.74% for 2019. And for passive index equity mutual funds, expense ratio drops from 0.17% for 2009, to 0.07% for 2019. By Silver (2017), active funds often aim to beat the relevant index i.e. “the market”. For example, S&P500 for the U.S., Taiwan Capitalization Weighted Stock Index (TAIEX) for Taiwan. The fund managers also compete with their peers, their performances are evaluated each quarter. The jargon
“we aim to be in the second quartile” means they want to be better than half of all fund managers, but not the very top because it might indicate they take too many risks.
The current performance will bring up the future incentive for managers, as an indirect incentive. Hedge funds win again. Lim, Sensoy, and Weisbach (2016) calculate that hedge funds’ indirect incentives are 1.4 to 6.0 times of direct incentive
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立 政 治 大 學
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N a tio na
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DOI:10.6814/NCCU202001043
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by different estimation. For mutual funds, the indirect incentive is only 28% to 66%
of those hedge funds estimated. Those huge incentives for hedge funds, no wonder Kostovetsky (2017) show there are brain-drain for mutual funds. That most skillful fund managers change their career to the hedge funds. Kacperczyk, Nieuwerburgh, and Veldkamp (2014) also support that top mutual fund managers are more likely to transfer to hedge funds later. By including hedge funds in my research, we can know how the most sophisticated managers in the industry performed given the freedom to operate. Del Guercio, Genç, and Tran (2018) even find those mutual managers who also co-manage hedge funds, their performance is lower 1.2% annually than those only manage mutual funds. That suggests agency problems that they prefer their hedge funds to mutual funds.
Table 4: Behavior of hedge funds vs. mutual funds
The investing behavior of hedge funds and mutual funds also different. Echoing previous research, Grinblatt et al. (2020) find two-third of hedge funds managers are contrarian, and they have the extraordinary stock-picking skill to buy undervalued stocks, not just simply provide liquidity. They earn 2.4% alpha annually and their skill is persistence. Also, about two-third of mutual funds managers have the momentum trading style. After adjusting for momentum, they earn no alpha. They suggest the
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立 政 治 大 學
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DOI:10.6814/NCCU202001043
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behavior is due to they have to fire-sale when market crash because of daily liquidity regulation, plus they want to capture retail customers’ attention by invest in high-performance stocks. Manconi, Massa, and Yasuda (2012) they show mutual funds’
actions when the financial crisis hits in 2017, securitize bond suddenly become
“toxic” and illiquid. They find mutual funds were fire-sale corporate bonds, not the securitize bond. They also tend to sell more junk bonds then invest-grade ones. That explains the risk propagation from securitized bonds to corporate bonds due to liquidity demand. Aragon, Martin, and Shi (2019) study two 21st century financial crises, the tech bubble (1999–2001) and the financial crisis (2007–2009). They study lock-up versus non-lockup hedge funds. They find by condition on borrowing costs, the lock-up premium is 5.9% annually. The high-borrowing costs environment can put extra pressure on liquidity provision.
Due to the loose regulation for hedge funds, to study them should take extra attention for their freedom and incentive in filling data, such as backfilling bias. The survival bias should be aware of as well. The market cycle and crisis can hugely affect everyone’s behavior, the market environment should not be treated as uniform and time-less. However, the exact timing of the market cycle is somewhat arbitrary and be decided ex-post mostly.
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立 政 治 大 學
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N a tio na
l C h engchi U ni ve rs it y
DOI:10.6814/NCCU202001043