Christopher P. Clifford

Hedge Funds and Discretionary Liquidity Restrictions

We study hedge funds that imposed discretionary liquidity restrictions (DLRs) on investor shares during the financial crisis. DLRs prolong fund life, but impose liquidity costs on investors, creating a potential conflict of interest. Ostensibly, funds establish DLRs to limit performance-driven withdrawals that could force fire sales of illiquid assets. However, after they restrict investor liquidity, DLR funds do not reduce illiquid stock sales and underperform a control sample of non-DLR funds. Consequently, DLRs appear to negatively impact fund family reputation. After the crisis, funds from DLR families faced difficulties raising capital and were more likely to cut their fees.During the recent financial crisis, more than 30% of hedge fund managers used their discretion to restrict investor liquidity through the use of “gates” or “side pockets.” Using a database of hedge fund investor interests, this paper is the first to empirically examine the determinants of these discretionary liquidity restrictions (DLRs) and their consequences for hedge fund investors. We find that funds enacted DLRs following poor performance and when their portfolio assets were more illiquid. However, despite claims from managers that DLRs protected investor interests by preventing fire-sales, funds that enacted DLRs continued to underperform comparable funds. Consistent with DLRs reflecting agency problems, we find that restricting investor liquidity during the crisis had a negative impact on fund reputation that spilled over across the hedge fund family. DLR funds and their family affiliates had a more difficult time raising capital and were more likely to cut their fees in the post crisis era. 1 We thank Chris Schelling and Clay McDaniel for valuable comments on discretionary hedge fund liquidity. We thank Xin Hong, Nathaniel Graham, and John Handy for valuable research assistance. Send correspondence to: Chris Clifford, Gatton School of Business, University of Kentucky; telephone 859-257-3850; email chris.clifford@uky.edu. Discretionary liquidity: Hedge funds, side pockets, and gates Abstract: During the recent financial crisis, more than 30% of hedge fund managers used their discretion to restrict investor liquidity through the use of “gates” or “side pockets.” Using a database of hedge fund investor interests, this paper is the first to empirically examine the determinants of these discretionary liquidity restrictions (DLRs) and their consequences for hedge fund investors. We find that funds enacted DLRs following poor performance and when their portfolio assets were more illiquid. However, despite claims from managers that DLRs protected investor interests by preventing fire-sales, funds that enacted DLRs continued to underperform comparable funds. Consistent with DLRs reflecting agency problems, we find that restricting investor liquidity during the crisis had a negative impact on fund reputation that spilled over across the hedge fund family. DLR funds and their family affiliates had a more difficult time raising capital and were more likely to cut their fees in the post crisis era. During the recent financial crisis, more than 30% of hedge fund managers used their discretion to restrict investor liquidity through the use of “gates” or “side pockets.” Using a database of hedge fund investor interests, this paper is the first to empirically examine the determinants of these discretionary liquidity restrictions (DLRs) and their consequences for hedge fund investors. We find that funds enacted DLRs following poor performance and when their portfolio assets were more illiquid. However, despite claims from managers that DLRs protected investor interests by preventing fire-sales, funds that enacted DLRs continued to underperform comparable funds. Consistent with DLRs reflecting agency problems, we find that restricting investor liquidity during the crisis had a negative impact on fund reputation that spilled over across the hedge fund family. DLR funds and their family affiliates had a more difficult time raising capital and were more likely to cut their fees in the post crisis era.

Blockholder Heterogeneity, CEO Compensation, and Firm Performance

We examine the relation between blockholder presence and firm performance with a focus on the inherent differences in organizational form and the stated intent among large shareholders. Using hand-collected information on blockholdings for a panel of S&P 1500 firms, we find that firms targeted by blockholders with organizational forms typically associated with performance-sensitive compensation or who file as active experience subsequent improvements in operating and stock price performance. Controlling for the endogeneity of blockholder presence and type, we observe no such improvements for firms targeted by blockholders with weaker compensation incentives or those taking a passive role. Moreover, performance effects are stronger for firms where information asymmetries are more pronounced and for firms with better corporate governance, indicating that, while outside blockholders may serve as a substitute for other monitoring mechanisms, it does not appear that they can fully compensate for shortcomings in governance.

Risk and Fund Flows

We study the impact of risk on mutual fund flows. Consistent with prior literature, we find evidence that net flows show aversion to risk. We show, however, that gross inflows and outflows are positively related to risk. While this result appears rational for outflows, it appears anomalous for inflows. We find that inflows are positively related to idiosyncratic risk, rather than systematic risk, and that institutional investors and incumbent investors are less susceptible to this behavior. Our results extend a growing body of evidence that finds certain investors making sub-optimal investment decisions, such as buying past winners, regardless of risk.Using an extensive database compiled from SEC N-SAR filings, we study how risk affects monthly flows to equity mutual funds over the period 1996 to 2009. Unlike most previous studies, we separately examine inflows, outflows, and net flows. We find that both retail and institutional investor inflows and outflows strongly chase past raw performance, but more importantly, they do so without regard to risk. This behavior appears to neither help nor harm investors, but it has significant implications for fund managers. Among other things, the welldocumented inability of fund managers to produce significant abnormal returns may be due to incentives rather than lack of skill or market efficiency.

Hedge Fund Boards and the Market for Independent Directors

We provide the first examination of hedge fund boards and their directors. The majority of directorships are held by extremely busy independent directors. These directors are sought by funds because they have more reputational capital at stake, making them independent and credible monitors whose presence can certify fund quality to investors. Busy independent directors are more likely to be hired by high-quality funds, and their departure from the board is associated with investor withdrawals. Moreover, funds with busy independent directors are less likely to commit fraud, abuse discretionary liquidity restrictions, or engage in performance-based risk shifting.

Investment Restrictions and Fund Performance

We examine why mutual funds appear to underperform hedge funds. Utilizing a unique panel of mutual fund contracts changes, we explore several possible channels, including: alternative investment practices (e.g., short sales and leverage), performance-based compensation, and the ability to restrict the funding risk of fund flows. We document that over our sample period, mutual funds were more likely to shift their contracting environment closer to that of hedge funds. However, this shift provided no benefit to mutual funds and we find no causal link between these contract changes and improvements in performance. Rather, our results cast doubt on the binding nature of investment restrictions in the mutual fund industry.

Investment in Human Capital and Labor Mobility: Evidence from a Shock to Property Rights

We study the effect of a change in property rights on employee behavior in the industry for financial advice. Our identification comes from staggered firm-level entry into the Protocol for Broker Recruiting. The agreement waived non-solicitation clauses for advisor transitions among member firms, effectively transferring ownership of client relationships from the firm to the advisor. After the shock, advisors appear to take better care of client relationships by investing in client-facing industry licenses, shifting to fee-based advising, and garnering fewer customer complaints. Our findings support property rights-based investment theories of the firm and document offsetting costs to restricting labor mobility.

Search Costs and Revealed Preferences for Idiosyncratic Volatility

We use capital flows into and out of mutual funds to infer investors’ preferences towards idiosyncratic volatility (IV). We find investors are more likely to both purchase and redeem funds with high IV. This pattern is concentrated among funds in the top quintile of IV, and it is stronger among retail investors, non-incumbent investors, and funds with lower visibility. Our results suggest that search costs contribute to investors’ preference for IV when making trading decisions. Our findings that IV can result in increased visibility and liquidity may also help explain the puzzling negative relationship between IV and equity returns.