Why Long-Short Hedge Funds Exit Profitable Trades Early

Even the most skilled hedge fund managers are likely exiting profitable trades too early.

A new research paper this month from the Federal Reserve Board suggests that risk constraints and monitoring costs dissuade managers from holding equity arbitrage positions for as long as they could, causing them to “leave money on the table.”

While the initiation of long and short positions is associated with “significant” abnormal excess returns, those positions are typically closed too soon, according tothe paper, authored by Fed economist Bastian von Beschwitz along with Sandro Lunghi, a director at manager monitoring firm Inalytics, and Daniel Schmidt, an assistant professor of finance at HEC Paris.

“Long-short equity hedge funds in our sample are skilled but constrained investors,” the authors wrote. “While their opening trades are clearly profitable (both on the long and the short side), they do not hold on to their positions until the alpha is fully exploited.”

For the study, the researchers used Inalytics data on the complete trading and portfolio information for the equity holdings of 21 hedge funds between 2005 and 2015, tracking both long and short portfolios.

They found that hedge funds earned cumulative excess returns of roughly 2 percent in the 250 days following the start of a long position, and had similarly positive results for short trades. But a “large fraction” of alpha was realized in the first 6 months following an initial investment, and the returns decayed afterward.

Because hedge fund managers are risk constrained – unable to take too large a position in any one stock – and because each arbitrage position requires costly monitoring, von Beschwitz and his co-authors said managers exited decaying investments sooner rather than holding them until the last drop of alpha was realized.

For example, the researchers found that by exiting trades when they did, the hedge fund managers in the study had foregone an additional 1 percent of cumulative excess returns over the 250 days following the closing of a long position.

But they more than made up for the money left behind, according to the paper. The same managers re-invested in new arbitrage trades – positions that resulted in 0.5 percent better excess returns than what they would have earned had they stayed firm.

“Within the same month, hedge funds generate more alpha with their opening trades than they forego but closing their positions prematurely,” the authors said, “proving that hedge funds recycle their limited risk capital into more profitable trading opportunities.”