What would you do if you won the lottery? Give it all away? Start a hedge fund? Retrofit an A380 with a basketball court (who wouldn’t)?Experts say that after the euphoria wears off you might find life to be a lot tougher. Countless TV shows have chronicled the assent and subsequent descent of lottery winners as they alienate their friends and family, blow all the money in Vegas and turn to a life of drugs. To borrow from the lexicon of investors, your quality of life might suffer a “reversion to the mean.”
But you might be lucky. Maybe the initial euphoria gives way to an enlightenment that continues well into the future. Perhaps you invest the money in a start up dream of yours and you sell out to Google a few years later.
Or maybe the euphoria fades and you go back to your old life – no better, but no worse.
These three possible outcomes are similar to those faced by a hedge fund manager that received a big inflow of new investment. A recent study by Katja Ahoniemi and Petri Jylha of the Aalto University School of Economics in Finland explores the relationship between fund flows and returns. The chart below from their paper shows the cumulative relative performance of funds with big inflows and outlines three possible outcomes of a big capital infusion: 1) performance continues to beat expectations, revealing that the new investor was “smart money” 2) performance reverts to the mean because the investment itself temporarily goosed returns by adding price pressure to securities in the portfolio and 3) no change in post-inflow returns since immediate arbitrage opportunities were fully exhausted in the month of the inflow.
First, the duo confirm that hedge funds experiencing big asset inflows tend to outperform those with small or negative asset inflows in the month of those allocations.
Price Pressure?
Ahoniemi and Jylha say that previous studies have focused on the performance of the fund in the period of the inflow. Higher returns, those studies suggest, are simply a result of price pressure caused by the manager having to increase all of their positions. But the duo says that for this hypothesis to be true, “…as the prices revert, funds that initially experienced a positive fl ow impact would under perform those that experienced a negative fl ow impact…”
But when they examine performance several months after the inflow, they find no such reversion to the mean. In fact, the performance continues to be a little higher, not lower, for funds that had a significant asset inflow (although no statistically significant (gray) in most cases).
Smart Money?
Okay. So the lifestyle of hedge funds doesn’t go downhill after the money flows in. But does it keep going up?
Unfortunately not. Had returns continued to be above average after the asset inflow, you might have concluded that investors were “smart money” – that they knew the returns were on their way up.
Not only did returns not pick up after asset inflows, but they actually fell off substantially around the time of the asset inflow (see chart below from the paper). In other words, new investment in a fund is a trailing indicator of returns, not a leading indicator. (ie. investors are return chasers)
Since post-flow performance doesn’t trend up or down (it just muddles along as before), what causes the sudden jump in returns at the moment new investments are made in the fund? Ahoniemi and Jylha hypothesis that hedge fund managers put the new money to work immediately by exploiting arbitrage opportunities they were previously unable to harvest. Once they have done so, those opportunities are gone for good.
In order for this to be true, however, the hedge fund manager would have needed to stare down some sweet arbitrage opportunities without levering up to exploit them. Like a dog on a leash desperately trying to grasp a juicy stake only inches from its mouth, the hedge fund just needs a bit more leash to cash in. When the assets start to flow, the manager lunges at the arbitrage opportunity and presto, it’s gone.
Although it sounds a bit outlandish, the duo points to research from the 1990’s showing that “wealth constraints of the arbitrageurs can prevent them from fully closing the gap.” So maybe it’s possible after all.
“Inflow” Alpha?
So if asset inflows provide a temporary burst of return potential, then how much of the history of hedge fund alpha can be attributed to this factor? Figure 7 in the paper shows the Fung & Hsieh 7-factor alphas of hedge funds without, then with the asset flows factor. As you can see, recent positive alpha turns negative when you account for the flow factor.
Apparently the asset flow factor has become more powerful in recent years. Between 2004 and 2008, it’s coefficient in the model above rose from around zero to nearly 0.15 by 2008. Overall, the authors say that a whopping 30 to 60 percent of hedge fund alpha can be attributed to this factor.
Lesson for lottery winners: The euphoria wares off. So keep buying more lottery tickets.
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