When Hedge Funds Lock Up Investor Money, the Whole Market Benefits

Research shows that strict hedge fund redemption policies lead to lower market volatility.

Paul Hanna/Bloomberg

Paul Hanna/Bloomberg

Strict redemption policies aren’t just good for hedge fund firms. According to new research, they’re good for the markets too.

Stocks purchased by hedge funds with more redemption restrictions tend to be less volatile and have better returns following surprise events, according to a paper published by Julia Elizabeth Reynolds, a financial economist for the U.S. Securities and Exchange Commission. She conducted the study while completing her post-doctorate program at the University of Lugano.

Research has already shown that ownership concentration can lead to demands for liquidity that are too big for the market to effectively handle, as Reynolds’ paper explains. This results in more volatile security prices.

But, according to Reynolds, there is a tool that investors can use to combat this problem: redemption policies.

Reynolds analyzed the impact of these policies by dividing hedge funds into two categories: “High redemption restriction funds” and “low redemption restriction funds.” Low restrictions meant redemption periods of about 30 days, lockups of two months, pay-outs of two weeks, and about ten redemptions per year.

Conversely, high-restriction funds had redemption notice periods of about 60 days, lock-up periods of about nine months, pay-out periods of nearly one month, and about four redemption periods per year. According to the study, these hedge funds had a 12 percent lower portfolio turnover rate than their peers.


Reynolds compared these two groups using data she aggregated from 13G and 13F filings, Lipper TASS, financial news analysis dataset Ravenpack, and the Center for Research in Security Prices. The total data set included 19,906 acquisitions of 7,294 unique stocks by 342 hedge fund management firms from the second quarter of 1981 through the fourth quarter of 2015.

According to the paper, stock prices were less volatile after a hedge fund with high redemption restrictions bought shares through block transactions than when shares were purchased by low-restriction funds. The decrease in volatility was up to 3.6 percent in the three quarters following the purchase.

“This result highlights that the redemption policies of hedge funds have real consequences for market participants and market quality,” Reynolds wrote in the paper.

The stocks owned by hedge funds with stricter policies were also found to be 4.7 percent less likely to be exposed to fire sales, or what Reynolds calls “flow-induced liquidity trading.” This is beneficial to other investors, who can identify their exposure to this type of volatility by looking at funds’ forecasted trading behavior, according to the paper.

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As for returns? Reynolds specifically looked at cumulative abnormal returns, which show the effect of lawsuits, buyouts, and other surprise events over short periods of time.

Her work showed that while cumulative abnormal returns around big transactions by low-restriction funds are almost always negative, those around high-restriction funds tend to be positive or zero.

Reynolds will be presenting her paper on Friday at the Financial Management Association’s 2020 conference. She declined to be interviewed for this article.