The Life Cycle of Hedge Funds

Deephaven Capital Management, a $4 billion hedge fund, yesterday closed up shop on two of its merger-arb funds.

The understandable reason: no one wants anything to do with mergers these days -- except for a certain Microsoft-Yahoo bid.

But the rapid decline in the Deephaven funds -- which operated for three years -- may not be all that unusual, a new study out of Germany suggests.

To investigate how returns change over a fund's lifetime, Dieter G. Kaiser of the Frankfurt School of Finance and Management looked at 1,433 hedge funds between 1996 and 2006.

He split them up into two broad categories:

- Funds which attempted to profit from broad directional movements in markets which include strategies like global macro, long/short equity, emerging markets and distressed assets.
- Funds which look to profit from mis-pricing opportunities. The strategies these funds use include fixed-income, convertible and merger arbitrage and market neutral strategies.

He found that while excess returns for market directional funds eroded from 2.25 percent to 1.9 percent after three years, there wasn't clear evidence of a life cycle.

The story was different for non-directional funds. They saw a much more dramatic decline in returns from 3.4 percent to 2.1 percent after three years.

Funds that bucked these trends usually had higher returns from the start.

Why does a hedge fund's return typically drop after the first couple of years? New funds have smaller teams which can respond more nimbly to mis-pricings and they're predominately founded in new markets to take advantage of arbitrage opportunities. But as the age old story with any investment strategy goes: once enough people learn about it, the opportunities start to vanish.

The charts below show the life cycle of directional and non-directional funds. (The measure of excess returns used by Kaiser is not the traditional alpha, but a relatively new measure called omega. The reason to use omega for studying hedge funds, some researchers have argued, is because hedge fund returns do not follow a standard normal distribution.)