Efficient markets require that prices are totally unpredictable, that future returns are in no way predictable based on current trading activity.

While this may be true for highly liquid markets, there is now evidence that in illiquid markets,  such as the secondary market for existing stakes in hedge funds, current buying and selling activity may have predictive power.

This, according to a new study by Tarun Ramadorai of Oxford, who has made a career of late in analyzing historical trading data from the hedge fund industry’s oldest secondary market, Hedgebay (see related posts).

Ramadorai’s use of secondary market data is novel because previous studies of investor interest in hedge fund have been based on new allocations (i.e. AUM growth).  As students of the industry are aware, hedge fund investors are return chasers.  When a fund posts good numbers, the money starts to flow in.

But as Ramadorai points out, AUM growth is actually a very “noisy” measure of investor interest and intent.  Subscription and redemption rules, lock-ups, and gates have a significant influence on the timing of new inflows.  In addition, inflows themselves can affect future returns – raising questions about whether new inflows were a predictor of future (positive or negative) performance or the very cause of that future performance.

Instead, “indications of interest” in buying and selling  stakes in gated, locked-up, or closed funds is a more exact measure of investor intent.

As you might expect, Ramadorai finds that buyers tend to come out of the woodwork following  periods of (strategy-specific) outperformance.  But what’s amazing is that the performance of those funds tends to continue to rise during the two years after the indication of interest to buy.  Fund return is represented by the blue line in the chart below taken from the paper.  (The red lines are +/2 2 standard error confidence intervals.)

As you can see, the cumulative excess return during the 2 years prior to the buying interest was about 13% (54 bps a month).  But rather than picking the top, these buyers participated in a further relative outperformance of about 4% during the ensuing 24 months.  Not a bad call.

The great thing about analysing secondary market data is that, like a stock market, researchers are able to examine both the bid (above) and the ask (expressions of interest in selling).  It turns out that sellers are also pretty good at judging the future prospects of their funds.  (Remember, both the buyers and sellers can be right at the same time since a transaction needn’t actually be executed.)

Sellers seem to get antsy after a few months of relatively poor returns.  Their decision to look for the exit door seems to be a harbinger of poor returns for the next two years.

So should you track these indications of buying and selling and attempt to trade accordingly?  And if so, should you track the buyers or the sellers?

To answer this question, Ramadorai constructs a portfolio of long positions in the funds that caught the eye of buyers and a portfolio of short positions in funds that sellers tried to dump.  It turns out that the demand portfolio significantly outperformed the supply portfolio.

Curiously, he also finds that the expressions of buying and selling interest from large investors (i.e. large trade tickets), were more predictive of future returns.  This seems to line up with research showing that large equity transactions from institutional investors embed more information about future returns.

Other researchers may have a lot to say about why this anomaly seems to exist.  But for now, we can safely say that this study is likely to be a successful predictor of the volume of future research on this topic.

To help our American readers celebrate the Thanksgiving holiday, we have harvested a bushel-full of news items that show an industry in such transition that it may soon become a leading cause of indigestion.

PE firms getting into the HF business: “…Private equity firms will need to become more like asset managers, offering buyouts as just part of their portfolio…large U.S. private equity firms, such as Blackstone, KKR and Apollo, have spread their wings into new fields like real estate, hedge funds and general asset management…”

HF firms getting into the PE business: “Hedge fund investors stuck in products with illiquid assets are increasingly seeing interest in their stakes from specialist private equity or other buyers as markets recover…”

HF firms getting into the banking business: “Hedge funds provided as much as 40 percent of the money raised this year by U.S. and European banks as they sought to offset losses and meet government capital requirements…”

Banks getting into the HF business: “…despite their moniker of ‘highly-leveraged institutions’, most hedge funds today operate with leverage less than a tenth that of the largest global banks…”

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The asymmetry of a performance-based fee is often seen as a “free option” for hedge fund managers.  After all, say critics, managers can win but they can’t lose.

Throughout the brief history of hedge funds, academics and researchers have attempted to measure the value of this option.  And quite often regulators implicitly acknowledge the existence of this transfer of value from investor to manager by banning performance fees or by requiring them to be symmetrical (the SEC’s regulation of mutual funds jumps to mind).

But when a hedge fund is under its high water mark, no performance fees are charged and the value of the option is minimal (at least until the fund gets close to the high water mark).   Put another way, investors in under water hedge funds have earned a performance fee holiday.  But when they redeem their investment during this holiday, the holiday ends.  If/when they buy another hedge fund, the high water mark is reset at the subscription NAV and the performance fees begin anew.

In aggregate, this amounts to self-destructive behavior on the part of investors and is tantamount to a transfer of wealth from investors to managers.  As we pointed out in June:

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A couple of weeks ago, we examined the “rational irrationality” in the way that closed-end hedge funds are traded.  While you’d expect a flood of new hedge funds listings during periods when secondary market discounts were low; that was not always the case.  In fact, a lot of hedge funds IPO’d closed end funds during recent rough spots for the industry.

Our friends at Opalesque report last week from Monaco where Tarun Ramadorai of Oxford University was discussing his research into the field of closed end hedge funds.  Regular readers may remember Ramadorai from a post we published last spring on secondary market pricing data from HedgeBay.

At the time, we only discussed the endogenous factors that went into determining hedge fund discounts – recent performance, historical volatility, portfolio liquidity etc.  But there was one important exogenous factor that helps explain both closed end hedge fund and closed end mutual fund pricing: interest rates.

As this chart from Ramadorai’s 2008 paper clearly illustrates, discounts fall (premiums rise) when interest rates are down.  (black and green = closed end HF premium, blue = 3 month T-Bill rate, both on a scaled vertical axis)

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When we first examined the secondary market for hedge fund stakes, there was only one company in the business, Hedgebay (see related post).   Several others jumped into the business early this year and were welcomed with sudden industry growth as hedge fund investors began to scramble for liquidity.

While all hedge fund investors could have used a little more liquidity over the past 12 months, funds of funds were apparently doing most of the scrambling – trying to respond to redemption requests on one side and redemption gates on the other.

Earlier this month the Wall Street Journal reported that the customer base served by HF secondary markets has changed as a result.  Reported the Journal:

“‘Last year, it was very much a local story dominated by individual investors in Swiss private banks spooked by actual and alleged links to Madoff funds on top of dismal performance,’ said Elias Tueta, co-founder of Hedgebay, which provides a platform to match up buyers and sellers of hedge fund stakes.

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Today’s panel discussions here at GAIM Cayman never strayed far from two central themes: fees, valuations, and (il)liquidity.  In fact, this was a common topic of discussion among participants during the coffee and lunch breaks as well.

Market to market?  But which market?

For example, participants questioned the most appropriate way to value gated hedge funds. Many hedge funds have recently created side-pockets and special purpose vehicles to isolate illiquid holdings or to meet redemption requests (using the SPV as an “in-kind” distribution). Apparently, this has given accountants, administrators and COO’s a serious headache.

Should these SPVs be valued at their NAV or at some discount? How would a modified (discounted) fee schedule affect the appropriate value of a side pocket investment?

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Academic research on hedge funds can be tremendously valuable to investors. But with increasing complexity, comes a greater chance that research conclusions can be interpreted in many different unintended ways.  For example, a widely publicized study released last week by Andrew Ang and Nicolas Bollen was presented by some as evidence that gating provisions themselves have a certain calculable cost.

As Reuters reported:

“In a paper titled “Locked Up by a Lockup: Valuing Liquidity as a Real Option,” Mr. Bollen and Columbia Business School’s Andrew Ang show that a manager’s right to block redemption requests “generates an implied cost of between 5% and 15% of the initial investment.”

This claim was likely based on the following statement in the introduction to the paper:

“…we show that a manager’s discretion to block redemption requests using gate restrictions or suspension clauses generates an implied cost of between 5% and 15% of the initial investment.”

Gate Provisions vs Gate Closures

Like Reuters, we read this to mean that the manager’s right (option) to cease redemptions was worth the equivalent of 5-15% of the value of the fund.  But a more detailed reading of the paper left us with the understanding that the manager’s actual decision to halt redemptions – not simply their option to do so – had the effect of immediately decreasing the value of the fund by 5-15%.

Ang and Bollen put a price on the investor’s option to redeem at their freedom.  The following table shows the value of a fund with a given volatility, a given likelihood of failure, and various expected mean returns (6%-14% per annum) under 5 separate liquidity regimes (columns from left to right: no liquidity, 2 yr lock-up + 3 month notice,  2 yr lock-up only, 3 month notice only, no restrictions at all).  The numbers represent the fair value (in dollars) for a fund with a $100 NAV on the day of its launch (i.e. at “Age=0″).

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Several commentators on these pages have wriiten about the hedge fund liquidity premium.  While it makes intuitive sense that investors demand compensation for locking in their money, it can be notoriously difficult to put a price on hedge fund attributes such as this.  When the only decision facing an investor is binary – to invest or not to invest – it is difficult to get a picture of the full demand curve for a particular fund.  Unlike in most other markets, investors don’t bid up or bid down the price of a hedge fund in an open market.

But there is one rough approximation of such a market for hedge funds.  And now one enterprising academic has used data from that market to determine how much investors value things like lock-ups and various other characteristics of hedge funds. That secondary hedge fund market is Bahamas-based Hedgebay.   Every month, Hedgebay brings together buyers and sellers of stakes in (mostly closed) hedge funds.  The funds trade at a discount or premium to their net asset value (NAV) depending on various factors.

In a study published in March, Tarun Ramadorai of Oxford University used 10 years of Hedgebay trading data to determine the effect of those factors on the premium or discount for a stake in one of the funds traded on the market.  Over the 10 year period analyzed, buyers have been paying a premium for these stakes in closed hedge funds.  The chart below was crated using data from the study and shows the premia and commissions paid for about 870 hedge fund stakes (excludes about 70 blow-ups that generally sold at around a 50% discount).

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It seems that many hedge fund managers and institutional investors used to work in the pest-control industry.  The most popular analogy at this year’s un-named institutional hedge fund conference (see posting below) is “A Roach Motel”.  Many readers will remember the famous insect trap where “Roaches check in, but they don’t check out”.  Well, it turns out there may be a few investments out there with similar characteristics (say, um, Amaranth).

As we have discussed in these pages, alpha hunting is best carried out in new and/or inefficient markets.  But the inefficiencies that give rise to alpha-generating opportunities often exist because these new markets lack liquidity (Amaranth aside).  A lack of liquidity can be particularly painful in times of distress when what little liquidity exists virtually dries up.  As a result, you can’t “check out” of your trade.

Several speakers have touched on the fact that portfolio management theory describes only a “normal day” in the life of markets – not a time of extreme distress.  After all, market mayhem does not facilitate an orderly run for the exits (witness the scene in the movie Airplane when the passengers were told to “assume the crash position!”).  Unfortunately, liquidity only exists when you don’t need it.

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