For the first time in history, three major league baseball players have negotiated contracts worth $300 million or more. The fortunate players, Manny Machado, Bryce Harper and Mike Trout, are naturally expected to work as hard as they can for their team every time they compete. This isn’t an unusual expectation of course. It is the basic premise of any employment contract: money for effort.
Superstars, eye-popping payouts and the confluence of skill and luck are common to both professional sports and hedge funds. Consistency of effort, however, appears to be a uniquely hedge fund problem. Ask 100 hedge fund managers if they work as hard to find investments in September as they do in May, and “of course I do” is likely to be heard 100 times in response. The data, however, suggests few discretionary managers are uncompromised by calendar year compensation and by the impact incentive fees have on money management decisions.
Just as hitting baseballs requires stepping up to the plate, compounding capital requires taking risk. Discretionary hedge fund managers, however, appear to routinely take less risk in the second half of the calendar year. This behavior depresses returns and pollutes the reality that stock-picking skills can generate attractive long-term returns.
Skill and Seasonal Effort
Returns to equity long/short strategies have been underwhelming yet researchers who study hedge funds have shown that on average, professional investors are quite adept at identifying favorable investments and many are truly skilled stock-pickers. There is evidence hedge funds identify favorable investments, profit from public information, and are adept at identifying mispriced securities that appear to be risky. There is even some evidence certain funds may time factors. Despite these findings, analysis also reveals the most common mechanism for accessing stock-picking skill, the discretionary long/short equity hedge fund, has on average, been a highly inefficient vehicle for compounding capital. One potential explanation for investor dissatisfaction is that a lack of discipline and process, among both allocators and the hedge funds they oversee, has contributed to the underwhelming performance.
The typical discretionary managers greatest strength is a mosaic investment approach paired with consistent, unbiased, and measured risk-taking. But it appears that years of underwhelming returns have led to a survival mentality motivating career-risk management. The evidence suggests investment effort is routinely expressed on a seasonal basis. One potential consequence of seasonal effort is that investors in hedge funds receive depressed returns that disguise the true ability of the manager.
Our statistical analysis of discretionary long/short hedge funds shows that the average fund manager in our universe of study systematically takes less risk in the second half of the calendar year relative to the first half. Worse, managers with strong returns in the first half of the calendar year become even more risk averse in the second half.
To quantify seasonal effort and reveal the magnitude of the issue, we measure effort through the lens of liquidity risk among discretionary long/short equity funds who file form 13-Fs, quarterly snapshots of hedge fund manager long portfolios. Our approach is quite simple; we want to know how badly a manager cares to own a particular stock and if his or her desire changes depending on the quarter. Our approach to quantifying desire relies on the days of liquidity a manager’s buying represents. Details on that approach follow. We assume this to be a reasonable test of effort because the desire to own an investment should be unrelated to what month of the year it is.
Market volatility contributes to mispricing opportunities, and on average, volatility is fairly consistent month-to-month (Fig 2).. It should therefore be the case that over a decade or more, there should be a roughly equivalent amount of appealing investments in, say, February, as there are in September. Yet when we analyze data extending back to August 2007, we find the typical fund reduces its risk appetite by an average of 17% in the second half of the calendar year compared to the first half of the calendar year (Fig. 3).
The values in Figure 3 represent the average days of volume a fund’s buying behavior represented when adding new long positions. These values are displayed for each quarter in a calendar year and each half of a calendar year (see the footnote which reviews the universe we analyzed). For example, in Q1 of 2008, the average discretionary fund manager was willing to consume 0.52 days of volume to enter a new long position.
The results of our very crude analysis appear to reveal that nearly every year, fund managers are the most aggressive in Q1 and the least aggressive in Q4. Unless we are going to believe that every year there are fewer appealing investments in the second half of the year, then we are forced to consider an alternative explanation: that there is an epidemic of seasonal effort among hedge fund managers. Either managers can’t find investments with equivalent appeal in the second half of the calendar year as they do in the first, which is implausible, or they have an ulterior motive – they want to protect their gains to ensure a bonus at year-end.
Academic research suggests the same reality, that seasonal effort not only exists, but is quite significant. A 2011 paper written by Andrew Clare and Nick Motson, titled “Locking In The Profits or Putting It All on Black – an Empirical Investigation Into The Risk Seeking Behavior of Hedge Funds,” took a different approach to evaluate effort, but reached a similar conclusion – that funds with profits to protect were more likely to “lock-in” their gains later in the year.
Seasonal effort is a violation of the contract between hedge fund managers and their investors. Managers are thought to be well incentivized through a hefty performance carry in addition to a management fee. But the incentive fee seems to motivate managers to work hard in the first half and play it safe in the second half. Seasonal effort likely results in lower returns for the investors in the fund.
We could of course be mistaken with our conclusion, that seasonal effort is a manifestation of the interaction between greed and loss aversion (a representation of Prospect Theory in action). It could be a manifestation of something else, perhaps the cadence of redemption activity depressing buying behavior in the second half of the year, or a reflection of abnormal buying behavior in the beginning of the year driven by institutional reallocation to equities. But these alternative narratives lack empirical support. The data suggests that seasonal effort exists, and we think the most likely reason is a behavioral one.
Firms charge, and allocators pay the same management fee in the first half of the year as they do in the second half. Yet fund managers seem to have a myopic attitude toward compensation and they may be getting away with episodic effort that reduces returns.
Investing appeals to us because of the intellectual rigor it requires, the fact that every trade has a winner and loser over a certain time frame. To succeed long term requires durable skill and consistent effort, and a little luck helps too, but it appears most investors do not strive to do their best at all times, they strive to do just well enough.
If Manny Machado, Bryce Harper, or Mike Trout, three of the best players in baseball, tried to “lock-in” their statistics for the season by taking the second half of the season off, fans would be outraged. Allocators, like Major League Baseball GMs, have invested in rosters of hedge fund managers they believe to be skilled and their investment is in accordance with a contract: money for effort. The research shows stock-picking skill exists, i.e. effort pays off. Fund managers have an opportunity to outperform their peers by living up to their side of the deal and giving 100% effort all year long, and allocators have an opportunity to outperform by holding them to it. Should both groups behave, the industry has the opportunity to generate returns that truly reflect an accurate mix of skill and luck – as opposed to what we likely see now: skill, luck and an unfortunate behavioral drag from seasonal effort.
K.C. is the founder of AQIS, a Connecticut based quantitative hedge fund manager.
Parag is a partner of AQIS
 For this analysis we constructed a universe of managers that averaged roughly 1,000 funds. The funds were required to have 75 positions or less, over 60% of their capital in companies with market capitalizations below $5 billion, and have less than $5 billion in invested equity capital. The goal was to find relatively concentrated, small and mid-cap focused managers, who were still small enough to hopefully not be in the business of asset gathering but be in the business of compounding capital.