This is a summary of "Investor Protection and the Long-Run Performance of Activism," by Pouyan Foroughi, Namho Kang, Gideon Ozik, and Ronnie Sadka, published in the <i>Journal of Financial and Quantitative Analysis</i>.
Over a four-year holding period, firms targeted by activists with high investor protection standards outperform firms targeted by investors with low investor protection standards by approximately 40%. This outperformance is due to long-term value added to target companies through long-term operational performance and enhanced valuation ratios, which are the result of reduced agency costs, improved corporate governance, and collaboration with institutional investors.
What Is the Investment Issue?
The authors analyze the effects of investor protection on the long-term performance of hedge fund activism. Activism offers an appealing angle through which to study investor protection’s effects on hedge funds for several reasons. Many hedge funds are adopting the activism strategy because of the challenges in producing alpha when other mainstream investing strategies are used. Unlike those of other, more popular investing strategies, the performance and results of activism are transparent because both activist hedge funds and target companies are often closely followed by investors and the media. In addition, activist hedge funds must file with the SEC when they plan to influence corporate management. The authors’ research can provide valuable inputs for the debates on hedge fund regulation and activism.
What Are the Findings and Implications for Investors and Investment Professionals?
The returns generated by target firms for which activists had filed a Schedule 13D at some point within the 12 months preceding portfolio formation do not meaningfully vary based on investor protection. Yet high-minus-low portfolios (i.e., long high portfolios and short low portfolios) of target companies sorted according to the investor protection level of activists indicate a significant positive risk-adjusted annual return of approximately 16%. In addition, significantly positive alphas and returns are seen with high-minus-low portfolios with Schedule 13D filings between the past one and four years. After industry adjustment, the high-minus-low portfolio produces a positive alpha of 11% per year.
The positive alphas generated by high-minus-low portfolios based on the past one to four years can largely be attributed to years two and three. The alphas yielded via high-minus-low strategies based on these time periods are notably positive, whereas those of the strategies based on year four are essentially the same as zero. The authors conclude that activism by high-investor-protection hedge funds leads to superior performance in the long term.
Higher investor protection results in lower agency costs, higher valuations, and overall more efficient investments. Although target firms outperform the market in the four years after the filing of a Schedule 13D, those whose activist hedge funds exhibit stronger investor protection attributes outperform those whose activist hedge funds have relatively weak investor protection over the same time period. The return spread between the hedge fund target firms with high investor protection and those with low investor protection is attained only after one year, which may be the result of proxy fights or market participants not immediately recognizing the importance of fund structure.
How Did the Authors Conduct This Research?
The authors obtain fund characteristic data on both “live” and “dead” funds from the Thomson Reuters Lipper TASS Database, such as assets under management, monthly hedge fund returns, audit date, and high-water mark. Using the information on such hedge fund characteristics, the authors create a fund investor protection measure. Their sample comprises more than 1,200 target companies and 211 investor protection scores for 170 unique activist hedge funds. Using regression models, the authors examine the multivariate relationship between investor protection and firm characteristics.
The authors test a trading strategy constructed based on activists’ investor protection standards. The authors form portfolios of companies for which Schedule 13Ds were filed during the period between j and k months before the formation of the portfolio.