Lack of disclosure requirements might help hedge funds maintain a competitive advantage—but it also enables them to take more risks than investors can see.
“Transparent funds are more sensitive to past performance than secretive funds, consistent with investors having a more difficult time making inferences when signals are obscured.”Research has shown that by secretly loading up on risk factors, these non-transparent hedge funds are able to earn risk premia that help them outperform in good markets. However, these same hedge funds are also much more susceptible to market crashes due to the extra risk taken, according to a study by Ellington Management Group’s Sergiy Gorovyy and Patrick Kelly, and Olga Kuzmina of the New Economic School.
“While the greater secrecy afforded hedge funds allows them to pursue proprietary investment strategies with less risk that other investors might mimic and free ride on their strategies, there is a natural tension between secrecy and the ability of a hedge fund’s investors to monitor the managers, who in the absence of monitoring may deviate from strategies which are optimal for the investors,” they wrote.
By examining the performance, transparency, and asset flows of hedge funds held by funds-of-funds from 2006 to 2009, the researchers found that highly secretive hedge funds outperformed the most transparent funds by 4% to 9% per year during good economic environments.
When the market turned, however, the secretive funds earned 7% to 17% less on average than transparent funds.
“Higher managerial skill or superior proprietary strategies of secretive funds on their own are not consistent with the observed pattern of performance,” the trio wrote. “Secretive funds may of course have a higher skill on top of taking more risk. However… the observed performance pattern during bad times is not consistent with being purely better market timers.”
While secretive hedge funds were more likely to crash than transparent funds, Gorovyy, Kelly, and Kuzmina found that investors were found to be more likely to exit transparent funds due to past performance.
“Transparent funds are more sensitive to past performance than secretive funds, consistent with investors having a more difficult time making inferences when signals are obscured,” they wrote.
Deprived of information, even the most “savvy and sophisticated” investors can be fooled into thinking they are paying for skill, when they’re really just getting risk premium, the trio argued.
“There may be a rationale for increasing disclosure requirements, so that investors understand what they are being compensated for when they receive their seemingly superior returns,” the researchers concluded.