Activist hedge fund managers are great, but not at being activists

Activist hedge fund managers are a controversial lot. They claim they take positions in undervalued companies to force changes in the business and unlock value. But because their portfolios are typically highly concentrated, the risk is if they fail to unlock value (or take positions in overvalued companies), the losses for investors are very steep indeed.

One of the most publicised examples has been Bill Ackman and his Pershing Square funds. He rose to fame (and became a billionaire) with his investments in Wendys, Target, and others which provided his fund with stellar returns. At the peak of his success in 2014, he listed a closed-end fund on the Amsterdam Stock Exchange which puts us in the enviable position to track his performance in real-time ever since. Unfortunately, he subsequently took doomed positions in Herbalife and Valeant Pharmaceuticals, so his fund lost 56% in the next three years while stock markets earned double-digit positive returns per year.

But, as a friend of mine likes to say, good managers don’t suddenly turn bad. Since spring 2018, his fund has been on a fantastic rally and made up all of its losses. Famously, Bill Ackman was one of the few investors who protected his portfolio from the Covid-19 epidemic in time.

Share price of Pershing Square Holdings since IPO

Source: Bloomberg

But the brief overview of Bill Ackman’s fortunes should already make you suspicious. Did he make money by being an activist investor or did he just display great stock picking and timing skill? After all, what does a Covid hedge in early 2020 have to do with shareholder activism?

In a new study, Martijn Cremers and his colleagues investigate activist hedge funds and how they generate their returns. The good news is displayed in the chart below: On average activist hedge fund managers are highly successful and have a statistically significant alpha of c. 4% per year. The companies these activist hedge fund managers invest in have a significantly better performance after these managers invest than before.

Performance of stocks before and after investments by activists

Source: Cremers et al. (2020)

But, and this is kind of bad news, activist hedge fund managers achieve this superior performance not by being activists. If they were good at unlocking value in mismanaged companies, one would expect that the stocks of companies they invest in would outperform otherwise similar companies that escape the attention of activist investors. But as the chart also shows, that is not the case. The relative performance of target companies is about the same to slightly worse than companies that have similar characteristics than their targets.

So, what gives? Cremers and his colleagues conclude that activist hedge fund managers are great at stock picking and great at timing their investments. They find the truly undervalued companies and invest in them shortly before they “pop”. And they sell their investments again if they think there is no more return to be had. In their study, Cremers and his colleagues show that the buy and hold return of activist hedge fund managers is significantly higher than the average investor’s is in the same stock. 

In the end, activist hedge fund managers are thus no activists. They are just stock pickers with a really concentrated portfolio. But they are really good at that.