Hedge fund activism is associated with higher short- and long-term returns, but is this because activists are value creators? Or are they just good stock pickers?
New research suggests the latter — that positive returns can be explained by the fact that hedge fund activists are good stock pickers with strong timing skills.
“There has been a lot of attention on the role that these hedge funds might have for . . . reshaping the governance of the companies targeted by hedge funds,” says Erasmo Giambona, a professor of finance at Syracuse University and one of the paper’s co-authors. Yet, no conclusive experimental approach has proven whether hedge funds actually create value.
The researchers felt it was important to revisit the issue and look at whether accounting for potential selection effect would lead to different results, he notes.
To do so, they used a matching methodology where, for each company targeted by a hedge fund, they tried to identify a companion company and then track the performance of both groups. If the matching was perfect, the companies targeted by hedge funds shouldn’t have performed better than those that weren’t. “When we actually implement this exercise, we find that that’s not the case,” he says. “In fact, companies that are very similar to hedge fund targets that were not targeted by hedge funds seems to perform better.”
The findings show that hedge funds aren’t really adding value, Giambona notes. “They are more or less capable of picking good stocks, stocks that will do well. But you could actually do even better if you pick stocks that are not targeted by hedge funds and potentially put in place changes to their governance that seem to be better than the changes put in place by hedge funds.”
Giambona suggests investors that may have previously thought they could invest in companies that recently became targets of hedge funds, with the assumption that hedge funds create value, should be cautious. “There are ways for companies to restructure that are even more powerful than the type of restructuring activities put in place by hedge funds.”
As such, he says investors should be careful not to overpay for stocks. “It might be worth putting in extra effort to identify companies that are very similar to hedge fund targets, but were not targeted by hedge funds to generate even more value.”