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The Future of Hedge Funds: Timing!

December 13, 2020

There’s an old joke. Even, if you like, a meta-joke. It probably dates back to vaudeville, and it takes the form of an exchange between the stage comic and a selected victim from the audience. It goes like this: Comic: Today’s your lucky day. I’m going to tell you the secret of a good comic delivery. All you have to do is ask. But I make one TINY request in return. Victim: What’s that? Comic: You must ask in exactly the right words. You must ask, “Mr. Comic, what IS the secret of good comic delivery. Go. Victim: What IS the secret … Comic: [Jumping in] TIMING!!! That is, as it happens, the secret of good comic delivery. Not So Funny That is also one of the great secrets of alpha. Mastering timing is the “quick” route to successful hedge fund performance. It is the secret in particular of the success of hedge fund activists in their acquisition and sale of corporate equity, according to a new study by Martijn Cremers, of the University of Notre Dame and associates. There is a view, propounded by many in academia and quite flattering to the practitioners in this space, that the corporate activists make their abnormal stock returns by improving the performance of undervalued firms, and in this way that they add value not only for themselves but for the buy-and-hold investors in the same firms. Brav, Jiang, and Kim made that case in a 2015 paper in the Review of Financial Studies. But Cremers and his co-authors (Erasmo Giambona, Simone M. Sepe, and Ye Wang) do not find support for this proposition in the facts they review. The activists are, they say, “good stock pickers, not value creators,” and their stock picking involves timing skill, for example by buying stocks when they are underperforming and ahead of positive abnormal returns. Methodologically, the key to this study is its use of a control group consisting of firms that have Tobin’s Qs comparable to those of the public corporations targeted by activist funds. The “Tobin Q” statistic is named for James Tobin (1918 - 2002), an influential economist and Nobel Laureate. It is the number obtained by dividing the market value of a company by the replacement cost of all its assets. The idea is that in an efficient market, market value should equal replacement value, so a Q above one is overvalued and below one is undervalued. Another methodological point, the authors define alpha for their purposes as “four-factor alpha,” that is, outperformance of a fairly rigorous definition of what market performance “should” be, designed so that momentum plays don’t count as stock-picking discernment. Timing and Undervaluation Cremers and his colleagues say that their evidence shows that stocks of firms targeted by activists (“target stocks”) outperform their control group of stocks in a short-term window around the initial 13D filing. But—and this is what undermines the value-building interpretation—the target stocks underperform the control group over the longer term. A plausible explanation of this is that the 13D filings themselves reveal to the larger body of non-activist investors that the target firm is undervalued. This means that the targeted stocks are brought around to the equilibrium condition (Q = 1) more quickly than the non-targeted control stock. As Cremers, et al., put it, “these filings provide, to investors, new information that reveals the undervaluation of these targets.” If the activities of the hedge funds were causing the outperformance of the targets, then one would expect the target hedge funds to outperform the control group. But that doesn’t happen outside a narrow window. The control group actually outperforms the target group in the subsequent five-year period. The activism of the activists doesn’t help buy-and-hold investors, who definitionally have a long enough horizon that they will reap the benefits of the move toward the equilibrium price whether it is during or subsequent to the window created by a 13D filing. “Activists significantly outperform in target stocks” these authors write, “over periods when buy-and-hold investors in the same stocks achieve no significant positive abnormal returns.” Erasmo Giambona is with Whitman School of Management, Syracuse University; Simone M. Sepe with University of Arizona; Toulouse School of Economics; Ye Wang with School of Banking and Finance, University of International Business and Economics., Beijing, China.

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