Hedge Fund Activism: Returns Follow Conviction

Mark Hulbert penned an interesting article in today's New York Times concerning a recent study of stock price performance in the face of hedge fund activism (defined as owning 5% or more of a company's shares). The conclusion: shares in companies that are the targets of such shareholder activisim outperform the market both before and after the hedge fund's position is publicly disclosed, and that ownership is typically for a longer time period than one might expect.

The authors examined nearly 900 instances from 2001 through 2005 of what they call hedge fund activism. The professors compiled their database in large part from the reports that hedge funds must file with the Securities and Exchange Commission whenever they acquire at least 5 percent of a company’s outstanding shares and intend to get involved in running the company.

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The professors found that the stock of the average company singled out by a hedge fund outperformed the overall market by 7 percentage points over a four-week period: the two weeks before and the two weeks after the hedge fund’s public acknowledgment that it was aiming at the company.

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In the year after that initial month of market-beating performance, the average target company’s stock kept pace with the overall market. And over the subsequent two years, the professors also found, the operating performance of the target companies improved markedly.

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The professors also examined whether hedge funds that try to change corporate behavior typically focus more on the short term or the long term. They found that in nearly half the cases they studied, the hedge fund still owned a large stake in the target company in October 2006. And in those cases when the hedge fund had sold its stake, the average holding period was close to one year. From this evidence, the professors conclude that “activist hedge funds are not excessively short term in focus.”

“Hedge funds provide an example of effective shareholder activism,” Professor Brav says. He noted that “when other institutional investors engage in activism — such as pension funds or mutual funds — they typically have not been effective in improving firm performance.”

I find the study's conclusions to be intuitive for one principal reason: conviction. Activist investing is a much harder, complex and time-consuming road to returns than simply establishing what one perceives to be an undervalued or momentum-fueled long position. I had written about some of the features of this type on investment when discussing David Tepper and Appaloosa, often requiring skills such as law and keen strategic thinking to augment stock-picking talent. So if a hedge fund is going to pursue this road to returns, it had better have strong conviction, and it generally does as evidenced by a position of significant scale. Why does the stock run up two weeks prior to disclosure? Because of the hedge fund scaling into its long position. Why does the stock continue to outperform two weeks after disclosure? Because other investors want to ride on the coattails of conviction, research and heavy-lifing (read: pursuing the activist agenda) of the activist hedge fund. But the really interesting feature is that superior performance appears to be sustained beyond a year after position establishment, and that the hedge funds still own substantial stakes after one year.

Think of a long-term activist investment strategy as being aking to much of what has happened in the world of statistical arbitrage. Initial holding periods and attractive returns in stat arb strategies were available in milliseconds,  almost akin to a riskless market-making strategy. Then as others got wise to this game capital flowed in, pushing returns at the short-end of the time spectrum to zero. So what did managers do? Extend holding periods, designing models with longer-term signals that offered opportunities for alpha but also required more capital and entailed more risk. The same type of evolution has taken place in people-driven (as opposed to model-driven) strategies. The quick money to be made on early information is a much harder game than it used to be. So what many funds have done is to trade not on pure information but on skill and strategy, ergo the rise of the activist hedge funds. But this takes a lot of capital, a lot of managerial resources and a lot of time. But as the study shows, this can result in outsized rewards. But it is a tough, tough game. And make no mistake, the game is getting tougher every day.