Investors should be wary of piling into popular hedge fund strategies, according to a paper recently published in the Journal of Economics and Business.
When too much capital targets the same investment strategy, the alpha produced by that strategy is diminished, found authors Zaur Rzakhanov, a senior lecturer at the University of Massachusetts Boston, and Gaurav Jetley, a managing principal at consulting firm Analysis Group.
The two researchers came to this conclusion after studying the impact of category-wide assets under management for merger-arbitrage hedge funds, which seek to profit by buying shares of companies shortly before they are acquired.
“If competition for assuming deal risk goes up, then one would expect the price charged for assuming the deal risk to go down,” the authors wrote. “Thus, arbitrage spread can be influenced by not just the variation in deal risk, but also by the intensity of competition among arbitrageurs seeking to assume deal risk and provide liquidity to shareholders.”
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After analyzing data from Hedge Fund Research on merger-arbitrage funds operating between January 1994 and December 2015, Rzakhanov and Jetley determined that in the average month, funds delivered 43 basis points in alpha. When the supply of merger-arbitrage assets was very low, however, average alpha rose to 66 basis points — a roughly 50 percent increase.
Interestingly, they did not find that individual fund size had a significant effect on alpha — only the level of competition. “The decline in performance seems to be driven by expansion in sector size, rather than by fund-level diseconomies of scale,” the authors noted.
Overall, they found that “the greater the amount of capital seeking a given number of investment opportunities, the stronger the aggregate effect on stock prices.” This is due to more investors trading in the same direction, reducing the potential profit for merger arbitrage investors, Rzakhanov and Jetley wrote.
“Smaller merger-arbitrage spread drives down alpha,” the authors concluded. “Greater intra-sectoral competition impacts prices and hinders a merger arbitrage hedge fund’s ability to deliver alpha and distinguish itself from competitors.”