What Causes Performance Persistence In Hedge Fund Activism?
Northeastern University – D’Amore-McKim School of Business
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Northeastern University, D’Amore-McKim School of Business, Finance Area
April 2, 2015
Hedge fund activists exhibit performance persistence in successive target firm 3-day announcement CARs. As activists accumulate experience, they devote more assets to activism, reduce their time between campaigns, and select larger firms in more industries. Further examination suggests that actual improvements in target firms, not activist reputation effects, drive these results. As activists gain experience, they become more aggressive in their stated goals and more frequently attain success in these goals despite increased target firm resistance. Short-term CARs do not reverse, and target firm long-term operating outcomes improve with activist experience.
What Causes Performance Persistence In Hedge Fund Activism? – Introduction
Hedge funds have received large capital inflows over the last several years, growing to nearly $3 trillion in assets globally by the end of 2014. The number of managers starting new funds has also increased, making the industry more competitive.1 After a strong period of performance in the 1990s and early 2000s, hedge funds as an asset class have underperformed the broader markets, causing practitioners and academics to question whether these managers have skill. For example, a 2013 Bloomberg report, using data from Hedge Fund Research, finds that in 8 of the last 10 years, hedge funds have underperformed the S&P 500 index.2 While the hedge fund industry as a whole has suffered disappointing performance, hedge fund activists have performed well, leading all hedge fund styles in 2014 despite increased asset flows – 20% of all hedge fund inflows in 2014 – and an increasing number of activist campaigns.
Given its relative outperformance, hedge fund activism presents a promising setting in which to identify managerial skill. We document persistence in 3-day CARs of successive activism campaigns, driven by persistence in good returns. We next examine whether this persistence stems from managerial reputation or from managerial skill. If reputation alone explains short-term stock return persistence, then activists should become less aggressive in their tactics with experience and their activism should have no long-term effect on target firms. By contrast, if skill explains persistence, then activists should become more aggressive in their tactics, and their activism should have discernable long-term effects on target firms. We test these two alternative explanations of persistence and find strong evidence in support of managerial skill.
Performance evaluation for money managers has been the subject of extensive debate. For example, many measures of performance, typically based on monthly returns, have been proposed and used to identify successful fund managers, yet several studies question whether these measures capture managerial skill given alternative explanations such as risk, model misspecification, survivorship bias, or weak statistical power of empirical tests (Kacperczyk and Seru, 2007). Hedge fund return data presents additional problems, such as backfill bias, selection bias, and misreporting bias, since these data are typically self-reported by managers. Perhaps due to all these biases, evidence on persistence in the hedge fund industry is mixed. For example, Brown, Goetzmann and Ibbotson (1999) show that hedge fund returns do not persist. Getmansky, Lo, and Makarov (2004) argue that illiquidity-induced serial correlation in fund returns explains the persistence in hedge funds at quarterly horizons that Agarwal and Naik (2000) demonstrate. In contrast, Jagannathan et al (2010) find relative performance persistence over a three-year horizon among hedge fund managers after correcting for measurement errors, backfill and lookahead biases, and serial correlation in the data.
Focusing on fund returns to test for skill has an additional complication: in equilibrium more money flows to managers with superior skill, leading to an erosion of performance over time (Berk and Green, 2004). Consistent with the theory, Aggarwal and Jorion (2010) and Boyson (2008) show that in comparison to more experienced managers, shorter-tenured managers tend to outperform and have better persistence. Jagannathan et al (2010) find that funds performing well attract new flows, but that this superior performance erodes beyond three years.
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