Not Just Fire Sales: Contrarian Hedge Funds Find Alpha

A new academic paper tells us something about the relationship between hedge funds and mutual funds throughout the business cycle, even as it builds on earlier scholarship that focused specifically on that same relationship during times of crisis.

The authors, Massimo Massa, an associate professor of finance at INSEAD, and two others, observe that there is an existing literature on “fire sales” by mutual funds that shows that hedge funds prey on mutual funds by buying valuable assets that mutual funds are forced to sell. In such cases, hedge funds can get bargains because they can hold out, whereas mutual funds are forced to sell by redemption claims.

This body of work extends back at least to a 2007 paper by Joshua D. Coval and Erik Stafford, “Asset Fire Sales (and Purchases) in Equity Markets” in the Journal of Financial Economics. Coval and Stafford found “considerable support for the notion that widespread selling by financially distressed mutual funds leads to transaction prices that occur below fundamental value.”

Forced selling is easy enough for armchair economists to understand. What Coval and Stafford found less intuitive was that there seems to be a good deal of fire buying in the mutual fund world as well: “[F]unds with large inflows behave as if they too are constrained to quickly transact in their existing positions, on average buying more of what they already own.”

Short Interest

Joseph Chen of USC Marshall School of Business and associates carried this line of inquiry further the following year. They focused on “two pieces of evidence that are consistent with hedge funds taking advantage” of opportunities created by mutual fund distress. One datum comes from times series’: the average returns on long/short equity hedge funds increase significantly in those periods when a larger fraction of the mutual fund world is in distress.

The second datum, at the level of individual stocks, is that short interest increases in advance of such fire sales. This occurs because the practice involved, as Chen et al observe in their article, Do Hedge Funds Profit From Mutual-Fund Distress? isn’t just a matter of picking up valuable underpriced assets mutual funds must sell. Hedge funds that are aware of the distress are in a position are in a position to short sell assets that they know will soon be coming on the market – and that they can reasonably expect will soon be for that reason at a reduced price – then they can cover those short sales at the distressed prices.

But Massa et al, the authors of the new paper, Contrarian Hedge Funds and Momentum Mutual Funds, carry the analysis another step forward. They indicate that there is no sharp bifurcation between times of distress on the one hand and “normal” times on the other. The same dynamic applies all around the business cycle: specifically, the presence of mutual fund activity within a particular market or asset class helps hedge funds discover alpha, by providing the hedge funds with constrained counter-parties to play against.

Alpha and Survival

Although marked “fire sales” are fewer in some periods than in others, it is quite generally the case that mutual fund managers face constraints related to the need “to cater to investors by investing in the hot stocks and by having a strong positive correlation  between their flow and the value of the assets in which they invest.”

Hedge funds, with their more professional investors, their deliberate opacity, and their constraints upon withdrawal, aren’t subject to those constraints. Thus, when mutual funds are constrained to follow a trend, hedge funds are in a position to be contrarians.

There are two quantifiable consequences: hedge funds are more likely to have positive alpha when their strategies involve assets with a lot of mutual fund market coverage; and, hedge funds in areas with high mutual fund coverage also live longer.

This survival effect is “concentrated for the hedge funds whose total length of redemption return period and pay out period exceeds 180 days.”   That fact is a strong confirmation about the authors’ views of the “hold-out” effect as key to the ability of hedge funds to game the mutual funds.

Though the authors don’t mention it, hedge funds can be on the wrong side of a similar dynamic. Notoriously, Long Term Capital Management almost certainly suffered from the consequences of front-running in its final days. According to an account by Nicolas Dunbar, in the final death spiral, the very brokerages that were “supposed to provide independent third-party price quotes” for LTCM joined in a feeding frenzy, “setting up trades on one phone line while quoting against LTCM on the other.”

Massa’s co-authors are Andrei Simonov and Shan Yan, who are both affiliated with of Michigan State University, Eli Broad Graduate School of Management.

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