Secretive Hedge Funds – Fooling the Savvy Investor?

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Secretive Hedge Funds – Fooling the Savvy Investor?

Sergiy Gorovyy

Ellington Management Group

Patrick J. Kelly

New Economic School, Moscow

Olga Kuzmina

New Economic School (NES); Columbia University – Columbia Business School

February 11, 2016


If a qualified investor has a choice between investing in a secretive fund and a transparent fund with the same investment objective, which should she choose? Prior work suggests that the secretive fund is better. Hedge fund managers generally use their discretion for the benefit of their investors (Agarwal, Daniel and Naik, 2009, Agarwal, Jiang, Tang and Yang, 2013). In this study we identify a subset of hedge funds managers, which appear to use their discretion to feign skill. Using a proprietary dataset obtained from a fund of funds, we document that hedge funds that are more secretive earn somewhat higher returns than their investment-objective-matched peers during up markets, consistent with earlier papers documenting skill-based performance, but significantly worse returns during down markets. This evidence suggests that at least part of the superior performance that secretive funds appear to generate is in fact compensation for loading on additional risk factor(s) as compared to their objective-matched peers.


In this paper we consider a situation over which managers have full discretion: how secretive they are vis a vis their own investors. Whether more disclosure is good or bad largely depends on the source of a fundís performance. If secretive funds attract more skillful managers that employ proprietary know-how strategies and invest into acquiring more information about the instruments they trade (i.e. generate an “alpha”), more disclosure would not be necessarily good, since it might allow other funds or investors to free-ride on these more skillful managers, reducing their competitive advantage and incentives for providing superior performance. If on the other hand, secrecy allows hedge funds to misbehave and take more systematic risk (i.e. high “beta”), than they claim the take, or perhaps more unpriced risk, such as uncovered option writing, then 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.

We argue that during relatively good times, the high-alpha and the high-beta/high-risk explanations for secretive funds may be observationally equivalent as long as we do not know the full model of hedge fund returns or do not observe all possible risk factors that explain variation in returns. On the other hand, during bad times, the high-alpha and the high-beta/high-risk explanations yield very di§erent predictions under the assumption that the risks, on which the high-beta/high-risk funds load, realize during these bad times Using a proprietary data base Örst used by Ang, Gorovyy and van Inwegen (2011), we compare the performance of secretive and transparent hedge funds during good and bad times and Önd that during an up market secretive funds signiÖcantly outperform transparent funds, controlling for the investment style; however, during a down market the secretive funds perform dramatically worse consistent with secretive funds, relative to their investment-style matched peers, loading on additional risks, which realize during the down market.

The beneÖt of our empirical setup lies in the opportunity for making such an assessment irrespective of knowing the true model that drives hedge fund returns, but instead by relying on the assumption that some of the risk factors that secretive funds may have loaded more aggressively on, also su§ered low returns during the period of the global financial crisis. We also examine the relation between áows and performance across secretive and transparent funds, because fund áows, especially outflows, can act as a disciplining mechanism for hedge fund managers. We hypothesize that secretive funds will be less sensitive to past performance than transparent funds as it may be harder for investors to infer deviations from the secretive hedge funds declared strategy. Consistent with this hypothesis, we find that áow to performance sensitivity is greater for transparent funds than secretive. However, secretive hedge funds become more responsive following their severe poor down-market performance.

FUll pdf below


secretive hedge funds
secretive hedge funds


secretive hedge funds

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