Never far from the headlines, hedge fund regulation has once again moved “above the fold” in financial newspapers around the world. In Washington, Brussels, Singapore and other places, policy makers are scoring political points and in some cases, even following their true (albeit misguided) beliefs that hedge funds are a major danger to the financial system.
The resulting race to regulate is in stark contrast to the widely-heralded “race to the bottom” that was supposed to have happened as jurisdictions around the world competed for the attention of hedge funds that were reportedly trying to escape government oversight. Some academics called this potential selection behavior “forum shopping” (see related post) but found that hedge funds did not, by and large, seek out the most laissez-faire jurisdictions when pursuing riskier strategies. York University’s Douglas Cumming and Sofia Johan, for example reported that:
“The data examined offer little or no support for the view that hedge fund managers pursuing riskier strategies or strategies with potentially more pronounced agency problems systematically select jurisdictions with less stringent regulations.”
But Cumming also wondered whether certain regulatory regimes tended to attract funds whose returns were more (or less) persistent than others. And, more specifically, what dimensions of hedge fund regulation tend to impact “return persistence” the most.
Return persistence is, of course, necessary precursor to alpha generation. If fund alphas are random, there are always going to be some winners and some losers. But when the winners of one period win again in subsequent periods and in numbers than randomness shouldn’t be able to achieve, then there is likely to be some combination of skill and a market inefficiency for that skill to exploit.
In a new study, Cumming and Na Dai of SUNY Albany’s Center for Institutional Investment Management examined several regulatory dimensions but focused mainly on the following three:
- Minimum Capital Requirements: They conjectured that a minimum hedge fund size would keep “lower quality funds” out of the jurisdiction and therefore promote greater return persistence by not introducing fly-by-night, “swing-for-the-fences” hedge funds into the mix.
- Restrictions on the Location of Service Providers: If a jurisdiction required, for example, a hedge fund to use a local accounting firm in a strip mall above a laundromat, then large institutional investors would surely avoid the funds in that jurisdiction. And since “market sentiment for a fund is is particularly vulnerable to rumors of a fund using low quality service providers,” these funds would tend to jump between return quartiles more easily.
- Distribution via Outside Distribution Companies: Hedge fund salespeople hate volatility. Just when a client is about to invest, the fund swoons for a month or two. Even though it recovers, the client’s heartburn is very real. Cumming and Dai wondered if the use of dedicated “fund distribution” companies (or more accurately, the legal ability to use such companies to distribute a fund) would lead to higher return persistence.
The duo divided hedge funds into quartiles based on returns during various 3 year periods, then they examined the alpha persistence with and without certain regulatory requirements. They discovered that the existence of minimum capitalization requirements tended to be associated with greater alpha persistence – but only across poor performers. The charts below show the percentage of funds that remained in the same alpha bucket across subsequent 3 year time periods and was created using data from Table 3 in the paper.
They also found that restrictions on the location of key service providers has a modest, but pervasive effect on performance persistence. However, after performing an additional regression analysis, the duo concludes that there is “strong statistical and economic support” for the notion that restrictions on service provider location “decrease the probability of performance persistence.”
They also found some evidence that the ability to use fund distribution companies to raise assets was associated with greater return persistence. They suggest this may be the result of the existence of external “certification” of returns by the distribution company, but acknowledge that there is generally “mixed support” for the notion that the allowable distribution channels in a jurisdiction drives return persistence.
When a fund is offered in a jurisdiction that allows them to be sold in “wrappers” that “make performance more opaque,” they also find that the persistence of top performers is lower while that of poor performers is greater. Essentially, it’s as if the cover provided by the wrapper allows poorly performing funds to survive and, conceivably, to thrive.
Finally, Cumming and Dai also examine whether funds with suspicious return anomalies – referred to, somewhat judgmentally, as “mis-reporting funds” in previous academic research – showed that “mis-reporting” funds had higher persistence. This should not come as a huge surprise since this segment of funds is defined by their return anomalies. Anomalies that, if influenced by the manager as suggested, would most likely make the fund look more persistent than it actually is; oddly enough, this was not true for the top and bottom quartile .
Have we gone from a “race to the bottom” to a “race to the top?” Time will tell. But the conclusions in the paper may well embolden those policymakers who are pro-regulation, but are concerned that regulatory intervention is necessarily detrimental to hedge fund performance.