Financial Conglomerate Affiliated Hedge Funds: Risk Taking Behavior and Liquidity Transformation

Abstract

We show that financial-conglomerate-affiliated hedge funds (FCAHFs) have more stable funding and lower flow-performance sensitivity than other funds even though they are less likely to impose impediments on withdrawals. Arguably due to their privileged access to funding, during periods of financial turmoil, FCAHFs are able to take more risk and to purchase less liquid and more volatile stocks than other hedge funds. During good times, instead, FCAHFs expand their assets less than other funds and are less exposed to systematic risk factors. Thus, FCAHFs appear to perform a stabilizing function for the financial system even though they do not generate higher returns for their investors.

Why Do Brazilian Bank-Affiliated Mutual Funds Underperform?

“…Under the compensation schemes typically in place in the fund industry, I shall argue that the strong correlation between flows and returns implies less convex payoffs, generating incentives for less active managing styles, less risk and lower expected returns. The pattern observed by (1), (2)) and (3) thus obtains.…”

“…And yet, there is evidence that funds affiliated to financial conglomerates are associated with lower expected returns ((1), (2)) and are less risky (3). What explains this pattern?…”

“…We then regress monthly fund flows on lagged ranking performance and control variables, with robust standard errors clustered by month. 3 Specifically, we estimate the following equation using OLS:…”

Bank-Intermediated Arbitrage

“…Our paper differs from this prior literature by showing that leverage provision by prime brokers to their clients may limit the ability of arbitrageurs to correct mispricing even outside of crisis periods. Finally, Giannetti and Kahraman (2017) and Franzoni and Giannetti (2017) study the trading behavior of funds with different funding structures. Giannetti and Kahraman (2017) show that open-end funds, which are more subject to limits-to-arbitrage frictions, are less likely to purchase underpriced stocks than closed-end funds.…”

“…Similarly, hedge funds with high share restrictions, having a lower degree of open-ending, also trade against long-term mispricing to a larger extent than other hedge funds. Franzoni and Giannetti (2017) then argue that financial-conglomerateaffiliated hedge funds have more stable funding than other hedge funds and are able to take more risk and to purchase less liquid and more volatile stocks than other hedge funds during financial turmoil.…”