Hedge funds and performance

Given all the attention hedge funds have been getting over the past few years, it is good to be reminded occasionally that when measured against a proper benchmark most hedge funds do NOT outperform. The following is from Ramit Sethi writing at Iwillteachyoutoberich.

I Will Teach You To Be Rich » Behind-the-scenes New Yorker article on hedge funds reveals they aren’t so sexy:

"...people with access to hedge funds — even they may be getting substandard returns in exchange for their participation in hedge funds. This is just another example of investor psychology and the importance of realizing that people are not always rational with their investments."

Sethi also cites Malkiel and Saha:

"After examining results of now defunct firms, Malkiel and Saha found that between 1996 and 2003 hedge funds made an average return of 9.32 per cent, significantly less than the 13.74-per-cent average return of funds included in the published databases."

Defnitely a good reminder and definitely not what you would expect if you just listened to popular press.

Article on what not to do when investing

Sometimes knowing what NOT to do shows us what to do. That is the case of Dowling and Lucey's paper entitled The 7 Deadly Sins of Investors. (FTR the target audience is Irish Investors, but their stories and advice are largely universal.

A few quick look-ins:

"In March 1999, an internet company called AppNet Systems....stated that the company would soon float on the stock market. ...investors ... rushed to buy. Unfortunately, many day-traders tried to buy shares in the company before it actually floated on the market, and ended up mistakenly putting their money into a similar-sounding company....The reason – the stock tickers of both companies, the symbols that appear on the trading screens of both professionals and day traders, were rather similar being APNT and APT. The share price of Appian shot up by over 140,000 percent in the space of two days"

While I am not totally convinced of the names for the "7 deadly sins", there is much good advice. For instance from the so-called Sloth section:

"The single greatest sin is falling victim to what is called ‘churn and burn’ :trading too
much. Every time you buy or sell a stock it costs you money....Rather than constantly changing your portfolio, you can improve your returns simply by buying and holding an investment... A study by US academics, Brad Barber and Terrance Odean, illustrates this principle. They found that the 20 percent of US households that traded the most earned average annual returns of 11.4 percent. The 20 percent of households that traded the least earned average annual returns of 18.5 percent. So, by doing very little, the low-trading households outperformed the heavy-traders by over 7 percent. Sloth pays.

The biggest culprits in over-trading are (young) men. Young men tend to be naturally aggressive and overconfident in their abilities. This leads them to change their investment portfolio too often. Barber and Odean, in another study, found that women are better investors than men, as they tend to trade less frequently."

CITE: Dowling, Michael M. and Lucey, Brian M., "The 7 Deadly Sins of Investors" (October 2006). Institute for International Integration Studies (IIIS) Available at SSRN: http://ssrn.com/abstract=938449

Does Investment Skill Decline Due to Cognitive Aging or Improve with Experience? by George Korniotis, Alok Kumar

Gee, another "why hadn't I thought of that?" one. (uh no comment!)

SSRN-Does Investment Skill Decline Due to Cognitive Aging or Improve with Experience? by George Korniotis, Alok Kumar:

"The economic costs of aging are considerable - older investors earn roughly 2% lower annual returns on a risk-adjusted basis. Collectively, our results are consistent with the hypothesis that older investors' portfolio choices reflect greater knowledge about investing but their investment skill deteriorates with age...."

While I am a tad unwilling to chalk up the lower returns totally to "declining congnitive abilities" (it could be that they are "out of the loop" and hence more uninformed), it is an interesting look at how aging affects investing.

Actually I am surprised this one hasn't had more play in the popular press! I just googled it and it did appear on MoneyScience, but no where else appeared. Weird.

Cite:
Korniotis, George M. and Kumar, Alok, "Does Investment Skill Decline Due to Cognitive Aging or Improve with Experience?" (January 2006). Available at SSRN: http://ssrn.com/abstract=767125

Who Loses from Trade? Evidence from Taiwan by Brad Barber, Yi-Tsung Lee, Yu-Jane Liu, Terrance Odean

Who Loses from Trade? Evidence from Taiwan by Brad Barber, Yi-Tsung Lee, Yu-Jane Liu, Terrance Odean:

In a paper that finds the exact opposite of San 2005, Barber, Lee, Liu, and Odean report individual investors lose when trading with individuals. This finding, which fits with previous work much more than San's surprise finding, is based on stock trades in Taiwan from 1995 to 1999.

From the paper:

"The trade data include the date and time of the transaction, a stock identifier, order type (buy or sell), transaction price, number of shares, and the identity of the trader. The trader code allows us to broadly categorize traders as individuals, corporations, dealers, foreign investors, and mutual funds. The majority of investors (by value and number) are individual investors."

Not surprisingly, this is many many many trades: "For the five-year period, ...more than 500 million buys and 500 million sales."

The methodology?

"On each day for each stock, we sum the value of buys made by a particular investor
group (corporations, dealers, foreigners, mutual funds, or individuals). The intraday return on these purchases is calculated as the ratio of the closing price for the stock on that day to the average purchase price of the stock. On each day, we construct a portfolio comprised of those stocks purchased within the last ten trading days."

"Statistical tests are based on the monthly time-series of returns, where we calculate three measures of risk-adjusted performance. "

1. "market-adjusted abnormal return by subtracting the return on a value-weighted index"
2. "estimate Jensen’s alpha by regressing the monthly excess return earned by each
investor group’s buy (or sell) portfolio on the market risk premium."
3. "...an intercept test using the four-factor model developed by Carhart (1997)." [these factors are "the return on a value-weighted portfolio of small stocks minus the return on a value-weighted portfolio of big stocks...the return on a value-weighted portfolio...of high book-to-market stocks minus the return on a value-weighted portfolio of low book to-market stocks, and...the return on a value-weighted portfolio of stocks with high recent returns minus the return on a value-weighted portfolio of stocks with low recent returns."

The findings?

When trading with institutions, individuals systematically lose:

"Institutions appear to gain from trade, though the gains from trading reach an
asymptote at approximately six months (140 trading days). After one month (roughly 23 trading days), the stocks bought by institutions outperform those sold by roughly 80 basis points. After six months, stocks bought outperform those sold by roughly 150 basis points.

In contrast, stocks sold by individuals outperform those bought. The magnitude of the difference is smaller than for institutions since most trades by individuals are with other individuals and do not contribute to the difference in performance between stocks sold and stocks bought. The large gains by institutions map into small losses by individuals merely because individuals represent such a large proportion of all trades."

This finding does fit existing theories on the informational advantages of instititions and once again reminds us that markets are not perfectly efficient. The question now appears to me more of how far from this perfect efficiency we lie.

You will want to read this one. Very interesting!

Barber, Brad M., Lee, Yi-Tsung, Liu, Yu-Jane and Odean, Terrance, "Who Loses from Trade? Evidence from Taiwan" (January 2005). EFA 2005 Moscow Meetings Paper http://ssrn.com/abstract=529062

Dollar Cost Averaging passes the test!

In Dollar Cost Averaging Brennan, Li, and Torous presents evidence that dollar cost averaging (investing equal amounts whether the market is up or down) actually works! In their words:

"evidence supports the view that the individual investors who follow this strategy in purchasing individual stocks to add to an existing portfolio are better off than if they followed the 'rational' strategies traditionally recommended by academics"

The short version of the paper is that while dollar cost averaging (DCA) may offer lower returns, it also lowers the risk. Consequentally, it seems that it does have an important roll to play in finance.

Again in their own words:

"We find, first, that, for an investor who is purchasing a diversified investment portfolio of common stocks represented by the CRSP value-weighted or equal-weighted indices, the DCA strategy, carried out over implementation periods of from one to six years, outperforms the lump sum investment strategy for all except the most risk tolerant investors. This seems to be due to the lower level ofrisk associated with the DCA strategy."

Yet another reason to use automatic investment plans!

As an aside, I love the paper's introduction:

"Practical or tacit knowledge typically precedes scientific knowledge. Crops were rotated long before the chemical basis of the practice was understood. Men learned to fly before aeronautics was well understood. Extracts of willow were described by Hippocrates as a pain remedy well before Bayer first synthesized aspirin....Therefore, given the relatively brief period of scientific study of financial markets, and the controversy that surrounds the interpretation of many of the findings, it is not surprising to find that a good deal of financial practice is stillgoverned by pre-scientific heuristics or maxims"

Cite:
Michael J. Brennan, Feifei Li, and Walt Torous, "Dollar Cost Averaging" (June 24, 2005). Finance. Paper 17-05.
http://repositories.cdlib.org/anderson/fin/17-05

Do Investors Reinvest Dividends and Tender Offer Proceeds? by Elias Rantapuska

SSRN-Do Investors Reinvest Dividends and Tender Offer Proceeds? by Elias Rantapuska

Short answer: Not really.

Rantapuska asks two interesting questions:

1. Are dividends and the proceeds from tender offers really reinvested?
2. Are the proceeds from cash flows from tender offers treated differently than those from dividends.

Using data from Finland, the author finds that a relatively small percentage of the proceeds are immediately reinvested and that investors do appear to treat dividends differently from tender proceeds.

In Rantapuska's own words:

"analyses show that households reinvest probably less than 1% and under no circumstances more than 8.1% of the dividends within two weeks of the payment. Institutions other than mutual funds are not reinvesting either. There is also strong evidence on investors being more likely to reinvest proceeds from tender offers than dividends. This result holds even when I control for the identity of the investor, size of the cash flow, and the extraordinary nature of tender offer proceeds payment. This result can be understood in terms of mental accounting: investors label corporate cash-disbursements to mental accounts of capital assets and dividend income and are more prone to reinvest the former."

Pretty interesting. And yet more evidence that DRIP programs (both for mutual funds and individual stocks) are probably a good idea.

The mental accounting idea is also intriguing. Purely economic investors would treat cash as cash regardless of its source.


Cite:
Rantapuska, Elias Henrikki, "Do Investors Reinvest Dividends and Tender Offer Proceeds?" (July 25, 2005). EFA 2005 Moscow Meetings, Forthcoming http://ssrn.com/abstract=675981

Covered shorts: the long and short of it

The New York Times has an interesting article on covered shorts. That is the tactic where you are both long and short the same stock.

This is what The Perry Corporation, a New York-based hedge fund seems to have done by buying shares in Mylan Pharaceuticls while simultaneously shorting shares (or more technically having Bear Stearns and Goldman Sachs short the shares).

So if the shares go up, Perry makes money on the long position but loses on the short position. On the other hand if the shares go down, Perry will lose money on their stock position, but make it up on the short position.

Of course this begs the question, Why? Why incur the transaction costs etc for no gain. The short answer is that they now have voting rights without being exposed to price fluctuations.

These voting rights are especially valuable in this case since the firm whose stock is being bought and sold is King Pharaceuticals. King is involved in a drawn out proxy contest as they are being taken over by Mylan. This takeover has grown heated as Carl Icahn (a shareholder in Mylan) moved to block the deal.

Not surprisingly, Icahn and shareholder rights groups are not pleased with Perry's deal.

Icahn:

"If hedge funds or any other investors are permitted to dictate the outcome of corporate elections without having economic interest in the companies, then any semblance of corporate democracy we still have in our country would become a travesty"

Nell Minow of the Corporate Library:

"It undermines the whole concept of linking ownership and control. It is not illegal, but the question is, 'Should it be?' I say, 'Yes.' The vote should accompany some kind of underlying interest."

What is curious however is that the article also states that Perry hopes

"to profit from the spread between the price Mylan offered for King shares, $16.49, and King's actual share price, which closed yesterday at $12.42. If the deal is completed, Perry stands to make over $28 million, based on figures in a filing with the Securities and Exchange Commission on Tuesday."

Unfortunately the article does not say how this profit would be accomplished and (as stated above) the rest of the article says that Perry's has no economic interest in the deal. (mmm, well $28 million seems to be interesting to me. ;) )

So how did they accomplish getting voting rights and gaining if the stock price appreciates? Two strategies come to mind. Note: the article and the illustration do NOT suggest that this is possible, so this is pure speculation.

• The short sale could be done via a limit order arrangement whereby the shares will only be sold in the event that the stock price goes below some price limit. This would prevent losses while allowing Perry to profit if the deal is done.
• With derivatives. Perry may have puts on the shares at the current price. The put would be allowed to expire if the price appreciates.

Unfortunately, as the article says, the details are still fairly "opaque" so we may have to wait and see.