Closed-end HF Pricing: Rational Irrationality

Fees 15 Jun 2009

When I was in business school, I recall asking my accounting professor why stock prices change in the absence of any new information.  If stock prices really did represent the present value of future cash flows (an allegedly idiosyncratic number), then how could all stock prices crash in tandem – with little or no fundamental rationale?  It’s as if stocks weren’t simply a representation of a company’s economic prospects, but instead had demand and supply characteristics all their own.

This is essentially the question raised in an interesting article by Oliver Dietiker of the University of Basel called “Investor Irrationality and Closed-End Hedge Funds.”

Dietiker jumps right to the point in the opening stanza:

“The purpose of my study is to question the rationality of people investing in hedge funds (HFs). My investigation is based on the following simple proposition: it is irrational to have similar expectations about the future performance of different HFs.”

“How can he question the rationality of investing in hedge funds?” I hear you say (with tongue firmly planted in cheek).   He asks why the discounts or premia attached to new closed-end hedge funds seem to apply to apply across the board to supposedly idiosyncratic investment funds.  After all, if the whole hedge fund value proposition is to deliver uncorrelated returns, then how you apply beliefs about one group of funds to your forecasts for another?

The existence of a common beta factor (or “alternative beta” factor) in the returns from a variety of hedge funds might explain the similarities between discounts/premia across different funds.  But that would also suggest investors are irrational since no one should want to pay alpha prices for alternative beta.

Either way, hedge fund investors, like equity investors come out looking somewhat less than “rational”.

New Money Raised by New Funds

The chart below from the article shows that hedge fund IPOs on the London Stock Exchange seem to take their cue from the discounts being applied to existing closed-end hedge funds (CEHFs). The blue line represents the discount on CEHFs and the gray bars show the number of new hedge fund IPOs.  Note the huge spike in new IPOs right around the time of the lowest discounts (highest premia).

Remember that Dietiker is not sayings its irrational for hedge funds to launch in a high premium environment (that makes perfect sense).  He’s suggesting that it’s the investors who are irrational for assuming that any forecast skill in the incumbents will necessarily replicate itself in the new IPOs.

But is this really “irrational”?  Ironically, Dietiker concludes that in the absence of any material information on a new CEHF, it is entirely rational to base their opinion on the only information they have – the expected performance of existing CEHFs…

“…the information contained in the prospectus usually does not considerably differ across funds, and it does not enable the investor to distinguish the specific qualities of a new fund from the seasoned funds. As a consequence, investors use the available information about the seasoned funds as a proxy for what to expect from the new fund, and therefore, new funds tend to get issued when investors are optimistic about the existing funds.”

New Money Raised by Existing Funds

But what if the investor has more information than that which is contained in the prospectus?  What if the investor actually knows the manager very well since they are a client of that manager?

In this case, the general discount/premium applied to CEHFs does not tend to drive the discount/premium applied to the secondary issue.  The chart below from the article shows that existing hedge funds have issued new shares even when their existing funds are trading at a discount.

Dietiker concludes that unlike with the launch of new funds, …the ability to raise new capital is significantly related to investors’ expectations about the specific fund” and not of the expectations of the CEHF market in general.

Clearly, investors use all available information: predecessor funds (in cases where they exist) or the average fund (in cases of new IPOs).  While transparency dogs “rational” valuation of CEHFs, Dietiker is forced to acknowledge the possibility that hedge fund investors may actually be rational after all.

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