What Happens When Hedge Funds Are Under the Gun

Managers get better at stock picking when they’re under pressure from redemptions, new research shows.

Illustration by II

Illustration by II

Hedge fund managers perform better under pressure — especially when there is a high management fee at risk, new research shows.

When hedge fund managers experience outflows, they tend to course-correct, “trading against the flow,” according to a new paper from scholars at the University of Manchester, Xinyu Cui and Olga Kolokolova.

In other words, managers become better at stock picking when they’re facing more pressure to perform well, the paper showed.

Cui and Kolokolova used data from EurekaHedge, TASS Lipper and Thomson Reuters Institutional (13f) Holdings database to document how hedge funds performed and what stocks they selected.

They found that stocks that hedge funds buy when they are experiencing large outflows deliver abnormal returns of 0.31 percent each month.

“The success of such against-the-flow trading reveals the stock-picking skills of hedge funds,” according to Cui and Kolokolova.

Meanwhile, “the positive ex-post abnormal returns of stocks bought by hedge funds decrease with the increase of fund inflows in both magnitude and significance,” the authors wrote.

According to the researchers, two conditions make it more likely that hedge fund firms will perform better following outflows. The first is higher fees.

“Outflows reduce the fee-base, which has an immediate effect on managerial compensation,” according to the paper, which was published on July 29. “The higher management fees, the higher compensation losses are.”

One way that hedge fund managers can increase their take-home pay following outflows is ensuring that their portfolios outperform, according to the paper, which allows them to generate higher income from performance fees. Thus, they may put more effort into ensuring that their investments are poised to perform well.

Conversely, when hedge fund flows increase, particularly rapidly, managers don’t need to do anything to achieve higher take-home pay, because they will earn more from the management fees on a larger asset base. According to the paper, this could be why managers of funds experiencing large inflows seem to take more conventional approaches to trading or to make less efficient decisions about their portfolios.

[II Deep Dive: Investors Weed Out Their Hedge Fund Managers]

Another factor when it comes to “trading-against-the-flow” is the notice required by hedge fund firms from investors who plan to redeem their shares. Those with shorter notice tend to have higher abnormal returns following outflows, according to the paper.

“Such funds are more likely to experience sudden outflows than those with long notice periods, and, thus, be under higher stress levels during periods of outflows,” according to Cui and Kolokolova.