An online monthly research publication by the Ivey Business School 

Volume 13, Number 4
April 2007

No free lunch

In award-winning research, finance professor Steve Foerster finds that investors in hedge funds aren’t getting as much as they hoped

When it comes to investing in the stock market, everyone is looking for a “free lunch.”

In recent years, some institutional investors felt they had found it in hedge funds, a term that derives from the expression “hedging your bets.”

In a recent study that won an award from the Alternative Investment Management Association (AIMA) of Canada, Steve Foerster looked at a particular style of hedge fund investing to see if it measured up to expectations. Foerster, Director of Ivey’s MBA program and the Paul Desmarais/London Life Fellow in Finance, has a number of research streams that focus on valuation of securities.

Hedge funds have been around for a long time, but became more popular during recent market downturns. The idea behind a hedge fund is to make money when the market is falling as well as rising. This is achieved through the ability to “sell short” as well as “go long.” In contrast, traditional “long only” funds make money only when markets are rising.

In Foerster’s study, he examined a particular hedge fund strategy, “equity market neutral.” For example, if Ford shares are undervalued relative to GM shares, an equity market neutral strategy would be to buy Ford stock and short sell GM.

If this style of hedge investing is doing what it’s supposed to, then there should be little market risk (called “beta”), and some measure of out-performance on a risk-adjusted basis (called “alpha”). “Alpha is the holy grail of investing, often referred to as a free lunch,” says Foerster. “This is a huge issue for institutional investors and pension funds who are looking to be rewarded above and beyond compensation for the risk they take.”

In his study, Foerster measured the alpha and beta for an equity neutral style strategy. “I found very low beta and significant alpha,” he says. “But when I brought into account economic and other factors that could be replicated through different strategies, then this free lunch goes away.”

The good news, says Foerster, is that this hedge strategy does better when there is more volatility in the market place or when the economy is not performing as strongly. “So these hedge funds are doing their job in terms of providing benefits when we most need them.”

In another stream of research, Foerster and Ivey professor Craig Dunbar study companies that go to market with an IPO, but withdraw before going public. In a previous study, Dunbar showed that few of these companies successfully come back to complete their IPOs.

In a paper that is forthcoming in the Journal of Financial Economics, Foerster and Dunbar looked at what distinguishes the companies that are “second time lucky.” “We found that there were two main predictors of success: having venture capital backing, and having a very reputable lead underwriter,” says Foerster.

In another stream of research, Foerster and Ivey professor Stephen Sapp examine a well-established method for valuing stocks, the dividend discount model. With this model, the value of a stock is based on the present value of future anticipated dividends. When growth is anticipated, the future stream of dividends reflects that growth. When the company faces greater risk or uncertainty, a higher discount rate is applied. The model is straightforward and theoretically sound, but Foerster and Sapp wanted to know how well it reflected the reality of the markets. They also wanted to better understand how firms determine their dividend policy.

In one study they examined the dividend history of the Bank of Montreal, a company that has paid dividends every year since 1829. This work formed the basis for articles that recently appeared in the Canadian Journal of Economics and the Journal of Applied Finance.

Foerster and Sapp found that Bank of Montreal paid out a higher percentage of its earnings as dividends prior to World War II than after, but in recent years has again refocused on dividends. This is typical of other Canadian firms, says Foerster. “After the war, companies tended to focus more on reinvesting and growing the business,” he says. “With the advent of income trusts, we’ve almost come full circle. Stocks are again being seen a source of cash flow.”

In another study, Foerster and Sapp tested the dividend discount model by applying it to the S&P 500 Index from 1871 to the turn of the 21st century. Applying the model, they found that stocks appeared to be generally undervalued prior to 1945, and subject to some deviations, fairly valued since then.

Does the dividend discount model work? “On the whole it does,” says Foerster. “The deviations are consistent with times when investors are either overly optimistic or pessimistic.”

Steve Foerster is the Paul Desmarais/London Life Fellow in Finance.
 

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