George O. Aragon

Hedge Funds as Liquidity Providers: Evidence from the Lehman Bankruptcy

Using the September 15, 2008 bankruptcy of Lehman Brothers as an exogenous shock to funding costs, we show that hedge funds act as liquidity providers. Hedge funds using Lehman as prime broker could not trade after the bankruptcy, and these funds failed twice as often as otherwise-similar funds after September 15 (but not before). Stocks traded by the Lehman-connected hedge funds in turn experienced greater declines in market liquidity following the bankruptcy than other stocks; and, the effect was larger for ex ante illiquid stocks. We conclude that shocks to traders’ funding liquidity reduce the market liquidity of the assets that they trade.

Portfolio Performance Evaluation

This paper provides a review of the methods for measuring portfolio performance and the evidence on the performance of professionally managed investment portfolios. Traditional performance measures, strongly influenced by the Capital Asset Pricing Model of Sharpe (1964), were developed prior to 1990. We discuss some of the properties and important problems associated with these measures. We then review the more recent Conditional Performance Evaluation techniques, designed to allow for expected returns and risks that may vary over time, and thus addressing one major shortcoming of the traditional measures. We also discuss weight-based performance measures and the stochastic discount factor approach. We review the evidence that these newer measures have produced on selectivity and market timing ability for professional managed investment funds. The evidence includes equity style mutual funds, pension funds, asset allocation style funds, fixed income funds and hedge funds.

Onshore and Offshore Hedge Funds: Are They Twins?

Contrary to offshore hedge funds, U.S.-domiciled “onshore” funds are subject to strict marketing prohibitions, accredited investor requirements, a limited number of investors, and taxable accounts. We exploit these differences to test predictions about organizational design, investment strategy, capital flows, and fund performance. We find that onshore funds are associated with greater share restrictions, more liquid assets, and a reduced sensitivity of capital flows to superior past performance. We also find some evidence that onshore funds outperform offshore funds, depending on the sample period. The results suggest that a funds investment and financial policies reflect differences in investor clienteles and the regulatory environment. This paper was accepted by Wei Xiong, finance.

Why Do Hedge Funds Avoid Disclosure? Evidence from Confidential 13F Filings

We study a sample of Form 13F filings where fund advisors seek confidential treatment for some, or all, of their 13(f)-reportable positions. Consistent with the hypothesis that managers seek confidentiality to protect proprietary information we find that confidential positions earn positive and significant abnormal returns over the post-filing confidential period. We also find that managers are more likely to seek confidential treatment of illiquid positions that are more susceptible to front-running. Overall, our analysis highlights important benefits of reduced disclosure that are relevant to the current policy debate on hedge fund transparency.

High-Water Marks and Hedge Fund Compensation

We examine the role of high-water mark provisions in hedge fund compensation contracts. In our model of competitive markets and asymmetric information on manager ability, a fee contract with a high-water mark can improve the quality of the manager pool entering the market. In addition, a high-water mark contract can reduce inefficient liquidation by raising after-fee returns following poor performance. Consistent with our models predictions, we find that high-water marks are more commonly used by less reputable managers, funds that restrict investor redemptions, and funds with greater underlying asset illiquidity. High-water marks are also associated with greater sensitivity of investor flows to past performance, but less so following poor performance. Overall, our results suggest that compensation contracts in hedge funds help alleviate inefficiencies created by asymmetric information.

On Tournament Behavior in Hedge Funds: High Water Marks, Managerial Horizon, and the Backfilling Bias

We analyze the risk choices by hedge funds that perform poorly, relative to other funds and in absolute terms - and test predictions on the extent to which these decisions are related to the funds incentive contract, investment horizon and dissemination of performance information. We find that tournament behavior is more prevalent in the (backfilled) period when funds may be at an incubation stage, before they start voluntarily reporting to a database. Excluding backfilled data, we find that variance shifts depend on absolute rather than relative fund performance. Consistent with theoretical arguments, the propensity for losing funds to increase risk is significantly weaker among those that tie the managers incentive pay to the funds high-water mark - suggesting a possible benefit from such incentive structures - and among funds that face little immediate risk of closure. Overall, the combination of factors such as reporting performance to a database, high-water mark provisions, and low risk of fund closure appear to make poorly performing funds more conservative with regard to risk-shifting.

Funding Liquidity Risk of Funds of Hedge Funds: Evidence from Their Holdings

We examine whether funds of hedge funds (FoFs) engage in costly fire sales of their hedge fund investments during the 2004–2011 period. We find that FoFs experiencing large outflows tend to liquidate holdings in funds with relatively few redemption restrictions (“liquid funds”), even when these funds perform well. A tracking portfolio that buys liquid funds involved in fire sales over the prior four quarters earns quarterly abnormal returns of 1.5%. We find no similar effects among illiquid funds, suggesting that trading costs from unanticipated redemptions explain the performance effects. We also show that liquidity mismatches between a FoF’s holdings and its investors helps predict liquidity risk in FoF returns, that is, FoFs with “excessive” exposure to illiquid funds outperform during normal periods but underperform during market crises. We find evidence that best performing hedge funds are unlikely to accept investments from FoFs that are subject to greater liquidity mismatches as hedge funds are likely to face significant liquidity spillover risks in case of large outflows from FoFs.  Agarwal (vagarwal@gsu.edu) and Shi (zshi@gsu.edu) are with Finance Department, J. Mack Robinson College of Business Georgia State University Atlanta, GA. Vikas Agarwal is also a Research Fellow at the Centre for Financial Research (CFR), University of Cologne. Aragon (george.aragon@asu.edu) is with Finance Department, W.P. Carey School of Business Arizona State University, Tempe, AZ.We examine the funding liquidity risk of funds of hedge funds (FoFs) by proposing a new measure, illiquidity gap, which captures the mismatch between the liquidity of a FoFs portfolio and the liquidity offered to its own investors. We find that hedge funds that are exposed to the flow-driven sales of FoFs, especially those with higher illiquidity gaps, subsequently exhibit lower abnormal returns. We show that FoFs with greater illiquidity gaps are less likely to be able to access star hedge funds, perform worse during market crises, and have a greater exposure to runs as evident from a higher sensitivity of investor flows to poor performance.