Purdue News

November 11, 2003

Bold, young hedge fund managers post strong returns, but fail more often

WEST LAFAYETTE, Ind. – A Purdue University finance professor's research shows that hedge funds' best results come when managers incur more risk and that this risk-taking behavior is systematically linked to a manager's level of experience. While mutual fund managers typically take on more risk as they age, experienced hedge fund managers take on less risk, which hurts the funds' returns.

"In selecting a hedge fund, an investor must weigh the higher probability of failure of a young fund against the lower predicted returns of an old fund," says Nicole Boyson, an assistant professor of finance at Purdue's Krannert School of Management.

Early hedge funds – the first was started in 1949 – were designed to mitigate, or hedge against, market risk. In contemporary practice, the name "hedge fund" has been extended to cover a number of strategies, some of which attempt to reduce market risk and others that attempt to exploit market inefficiencies.

Hedge funds employ complex strategies that often involve leverage and high-volume trading in a number of markets. including stocks, bonds, currencies, commodities, options and futures. Similar to venture capital and private equity funds, hedge funds are organized as private partnerships not subject to Security and Exchange Commission oversight. So hedge fund managers can be – and generally are – secretive about their trading strategies so as to avoid copycat traders.

This secrecy makes it difficult for a potential hedge fund investor to choose a fund, Boyson says, but diligence is in order since the minimum hedge fund investment is usually about $500,000. Her research provides some dos and don'ts for potential hedge fund investors.

Boyson says that young hedge fund managers take on a higher level of risk, which improves their returns. By contrast, the older hands in the business take on less risk. Boyson's research demonstrates that the difference in returns between a 52-year-old manager and the average (47-year-old) manager is about 4 percent annually. Her follow-up research shows that young managers who have been strong performers in the past outperform old managers who have been poor performers in the past by a statistically and economically significant 9 percent per year.

There are a number of solid reasons why older managers are unwilling to take on the types of risk that might lead to better performance.

"Hedge fund managers, in general, and particularly older hedge fund managers with larger funds, are making boatloads of money," Boyson says. A hedge fund manager with a $115 million fund in 2001 earned about $4 million that year, compared to a mutual fund manager who earned about $400,000.

Boyson says older hedge fund managers also have large amounts of their own money invested in their funds, so they're concerned about their personal net worth.

"At the beginning of its existence, a hedge fund undergoes an incubation period when the only significant investor is the fund manager," Boyson says. If his investment is successful, he then solicits others to invest in the fund. At that point, the hedge fund manager is able to invest others' money to execute his market strategy.

Boyson's research shows that younger managers tend to "herd" less than their older counterparts and make the bold investment plays that harvest superior returns. However, young hedge funds also have a high rate of failure. And young managers are under intense competitive pressure: Boyson says they have to outperform two-thirds of the competition to keep their jobs.

Unlike mutual funds, hedge funds fail early and often. Of the 982 funds with at least $5 million in assets in the database Boyson used for her research, almost one-third died between January 1994 and December 2000, the first period for which relatively complete information on hedge fund performance is available.

If a fund fails, Boyson says there are seldom second acts for hedge fund managers.

"Reputation is so important that rarely do you see a failed hedge fund manager start another fund," Boyson says. So those funds and managers that do survive tend to want to hold on to what they have, and they begin to herd and shy away from taking on the types of risk that will generate superior returns.

All this leads Boyson to say the hedge fund business carries what she describes as a "winners' curse" for potential investors.

"It's hard to find older managers who can beat the industry's returns, but the young managers are more prone to failure," she says.

She hedges a bit on her opinion on the market risk hedging that the funds were originally designed to provide.

"That hedge funds consistently protect the investor against downside portfolio risk has not yet been proven conclusively," she says.

Should hedge funds be part of an individual or institutional investor's portfolio?

"Many people buy hedge funds chasing high returns on the recommendation of the proverbial brother-in-law," Boyson says. "This approach has its obvious drawbacks.

"Instead, those who are dead set on investing in a hedge fund should go through a consultant from, for example, an accounting firm or an investment bank with access to a large database of hedge fund managers."

Such resources include Credit Suisse First Boston's TASS database, which Boyson uses in her research.

"If you can make a case for a hedge fund in your portfolio, I'd recommend a more diversified approach – a fund-of-hedge-funds (FOF), which is a hedge fund that invests in a portfolio of other hedge funds, like a mutual fund."

The downside is that investing in FOFs is very expensive, Boyson says. Not only does the investor pay the FOF manager a fee, but also the fees associated with the underlying funds in which the FOF manager invests.

"And you need to invest a fairly substantial portion of your portfolio if you're serious about a hedge fund. If you have, say, only 5 percent of your portfolio invested in hedge funds and, best-case scenario, your hedge funds perform very well during a given year, that really doesn't have much of an effect on the performance of your overall portfolio."

But, despite the risks, plenty of investors buy hedge funds.

Today, hedge funds have a total capitalization of $600 billion to $700 billion, which pales compared to the $7 trillion invested in mutual funds. However, hedge funds regularly employ leverage, borrowed funds that put an estimated two to three times as many hedge fund dollars into play in the markets at any one time.

This market leverage means even more risk both for the funds themselves and, potentially, for world markets.

The hedge fund risk poster boy is Long-Term Capital Management, which with its Nobel prize winning stable of managers, had multiplied its market bets significantly – 120 times by one estimate – through leverage. And even though many of the fund's big plays were ultimately proven correct, its lenders were unwilling to wait when Russia defaulted on its sovereign debt in 1998.

"The Federal Reserve Board put together a consortium of investment banks to bail Long-Term Capital Management out because of concerns over how its failure could have roiled markets worldwide," Boyson says.

One other anomaly Boyson points out about the hedge fund business is its gender bias. "Of the almost 1,000 funds I looked at, there were only five or six female managers," she says.

Writer: Mike Lillich, (765) 494-2077, mlillich@purdue.edu

Source: Nicole Boyson, (765) 496-7877, nboyson@mgmt.purdue.edu

Purdue News Service: (765) 494-2096; purduenews@purdue.edu

Note to Journalists: Nicole Boyson's two working papers, "Why Do Experienced Hedge Fund Managers Have Lower Returns?" and "Do Hedge Funds Exhibit Performance Persistence? A New Approach," are available on her home page.

Several theories of reputation suggest that managers' career concerns affect their decisions. We investigate these theories by studying the behavior of hedge fund managers over their careers. In contrast with mutual fund managers who incur more risk over time, hedge fund managers take on less risk over time. This finding is consistent with certain industry characteristics which imply that experienced managers have "more to lose" in personal wealth, current income, and reputation should their funds fail. Most important, the propensity of experienced managers to reduce risk explains their underperformance. These results have implications for fund selection and incentive contract design.

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