Professional Documents
Culture Documents
Jung-Min Kim†‡
Department of Finance
Fisher College of Business
The Ohio State University
ABSTRACT
On average, hedge funds fail slowly rather than through sudden crashes. I model a fund’s
probability of failure using a dynamic logit regression and find that fund failures are predicted by
past performance and fund flows measured with a lag of seven months. Hedge funds fail as poor
performance over a period of time leads to fund withdrawals by investors. A fund’s failure risk
predicts negatively the fund’s future returns. Sorting hedge funds into quintiles by the predicted
failure probability based on information lagged by seven months, I find that the return spread
between the two extreme quintiles is 7.6~8.9% per year after adjusting for nine commonly used
hedge fund risk factors and a return smoothing effect over the period of July 1996 to September
2007. The negative failure risk effect on future fund returns is sharply higher for funds with weak
share restrictions and is not subsumed by the findings of the prior literature.
†
I would like to thank Kewei Hou, Andrew Karolyi, Scott Yonker, seminar participants at the
Ohio State University, and especially my dissertation advisor, René Stulz, for their helpful
comments and suggestions. The Dice Center for Financial Economics provided financial support.
All errors are my own.
‡
Please direct correspondence to Jung-Min Kim, 700 Fisher Hall, 2100 Neil Ave, Columbus, OH
43210. Telephone: (614) 292-2979. Fax: (614) 292-2418. E-mail: kim_1724@fisher.osu.edu.
1. Introduction
The growth of the hedge fund industry has been very rapid in recent years.1 At the same
time, hedge funds tend to become headline news due to spectacularly high or low returns. Since
they are largely unregulated and their operations lack transparency, both regulators and hedge
fund investors are concerned about the potential failure of hedge funds. Thus, this paper attempts
to examine hedge fund failures in a systematic way. More specifically, I investigate how hedge
funds fail, whether failure is predictable, and whether a fund’s probability of failure is helpful to
Much attention is paid to hedge fund failures which result from a crash. Typical well-
known hedge fund failures include the collapse of Long-Term Capital Management (LTCM) and
Amaranth.2 This kind of failure can be driven by market risks (e.g., LTCM and Amaranth), a
sudden funding withdrawal (e.g., Peloton), or operational risk such as fraud (e.g. Bayou).3 An
alternative model of hedge fund failure is that poor performance over a period of time leads to
fund withdrawals by investors. Thus, eventually, the fund becomes too small to be profitable for
If hedge funds fail through crashes, there is no reason for performance to be worse before
the crash. In fact, funds could take risks that imply a small probability of large losses and earn a
positive alpha for taking these risks. However, if funds fail slowly as poor performance over a
period of time makes investors more likely withdraw their funds, there are good reasons to
believe that funds with higher failure probability can be expected to have poorer performance.
1
According to the TASS Asset Flows report, net hedge fund assets have grown from $72 billion at the end of 1994
to $1.79 trillion at the end of 2007.
2
See Jorion (2000) for LTCM and Chincarini (2007) for Amaranth
3
See Brown, Goetzmann, Liang and Schwarz (2007, 2008) for more detailed analysis on operational risk using the
SEC filings (Form ADV)
1
As a hedge fund becomes concerned that investors are likely to withdraw capital due to poor
performance, it may be forced to change its investment policy. In particular, it has to take more
positions in liquid assets so that it can meet redemption requests and it has to avoid trades that
could lead to sharp losses in the short-term that would accelerate withdrawals.4 To become more
liquid, a fund may have to liquidate some illiquid positions, which can be costly and hence
reduce its performance. These concerns about meeting redemptions and minimizing the risk of
fund outflows are heightened for funds with short share restriction periods (i.e., funds with a
short redemption notice period and a short lockup). Such funds are therefore more likely to
perform poorly when their failure risk is high because they have to avoid profitable trades that
they could undertake if they were not concerned about redemptions. I would therefore expect
funds with weaker share restrictions to have lower expected returns when their probability of
failure is high.
By plotting how the average performance and fund flow of failed funds evolve over time
until they fail, I show that, on average, hedge funds fail slowly due to gradual fund outflows
following poor performance. Given the slow failure, I first examine the predictability of hedge
fund failures. I employ a dynamic logit model in a manner similar to Shumway (2001) and
Campbell, Hilscher and Szilagyi (2008) who apply the model for forecasting corporate failures
or bankruptcies based on accounting and stock market variables. Motivated by prior literature
and economic intuition, I propose several covariates for the failure prediction model: past
performance, number of months since a fund achieves its recent maximum value (to proxy for
investor impatience), past fund flows, frequency of missing asset size (to proxy for hiding fund
4
An alternative view could be that such a fund would gamble for redemption by taking large risks so that it has
some chance of superior performance. Presumably, if the fund had potential risky trades with high expected profits,
it would have made them already. I would therefore expect such risky trades to have low expected profits and to be
associated with poor expected future performance.
2
outflows), fund age and size, volatility, share restriction periods (redemption notice and lockup
periods), and managerial ownership. Further, I examine how historical (1-month, 7-month, and
13-month lagged) information can help predict fund failures, and find that fund failures are
possibility that fund failures could be triggered by an extremely large negative return and find
hedge fund failures are not typically associated with an extreme negative return. Therefore, the
results of the failure prediction model are consistent with the slow failure model. Overall, past
poor performance, higher investor impatience, fund outflows, higher frequency of missing asset
size, and smaller fund size increase failure risk. Among constant failure predictors, longer share
restriction periods and higher managerial ownership are associated with lower failure risk
because they can attenuate the threat of capital outflows. Moreover, since there are several
reasons that funds stop reporting to a database and some of them are not clearly related to fund
failures, I consider two different definitions of failures (first, failure means liquidation only and
second, failure means all funds that stop reporting to a database) and find that the results of the
Another implication of the slow hedge fund failure model is that the predicted (ex ante)
failure risk of hedge funds can affect their future performance. Prior literature documents that
past poor performance is a main reason for hedge fund failures (e.g. Liang (2000), Brown,
Goetzmann and Park (2001), and Grecu, Malkiel and Saha (2007)). But, they do not provide
direct evidence on how the (ex ante) failure probability of individual funds affects their future
performance. In order to obtain the ex ante failure probability measure, I estimate the failure
prediction model every month using a rolling-window approach based on only prior information,
instead of using the parameter estimates obtained from the full-sample results. With this way of
3
constructing the predicted failure probability, I can avoid any potential look-ahead bias, perform
an out-of-sample prediction analysis, and implement a trading strategy. To see whether a fund’s
failure probability is helpful to predict the fund’s future returns, I sort hedge funds into quintiles
by the predicted failure probability based on 7-month lagged information that mitigates a
concern about information availability when a trading strategy is implemented. By examining the
monthly time-series returns of quintile portfolios, I find that the return spread between the two
extreme quintiles is 7.57% (when failure means liquidation) or 8.86% (when failure means funds
that stop reporting) per year after adjusting for nine risk factors (Fung and Hsieh’s seven factors,
book-to-market factor, and momentum factor) and a return smoothing effect over the period of
I address several potential concerns about the results. The first concern is that hedge
funds indeed fail by a sudden crash, but their failures may look gradual because they have long
share restriction periods so that investors cannot quickly withdraw their money after a bad event.
If this is true, at least a sub-sample of failed funds with the highest-level share liquidity should
show a sudden drop of performance and fund outflows. However, the event-time analysis for the
failed funds with no lockup and no redemption notice period suggests that they also fail slowly.
The second concern is that the large return spread based on failure risk may be driven by large
negative returns in failure months. Thus, I remove failure month returns and find the return
spread is still 7.19~8.08% per year, suggesting that the negative relation between failure risk and
future performance is robust. The third concern is that failed funds tend to be smaller than their
peers. To mitigate the concern that the large return spread may be mostly driven by extremely
small funds, I remove the bottom quintile of the sample based on fund size and find the return
4
Since the predicted failure probability is a function of the covariates and several
covariates are known to predict future performance from the prior literature, it is important to
examine whether the failure risk effect on future returns is subsumed by covariate effects. To
examine the issue, I implement several specifications of cross-sectional regression at the fund
level and find that the negative failure risk effect on future fund returns is not subsumed by the
missing asset size, fund age and size, volatility, share restrictions, and managerial ownership.
This paper is related to the hedge fund literature as follows. First, it extends the literature
on hedge fund failures. Prior literature (Brown, et al. (2001), Baquero, Horst and Verbeek
(2005), Malkiel and Saha (2005), Rouah (2005), Chan, Getmansky, Haas and Lo (2006), Grecu,
et al. (2007), Liang and Park (2008), and others) mostly investigates the factors that affect hedge
fund failures. In contrast, this is the first paper to examine how the predicted (ex ante) failure
probability of individual hedge funds affects their future performance. Second, it is also related
to the literature that documents a cross-sectional difference in returns in the hedge fund industry.
Prior literature documents that (1) some hedge funds persistently perform better than other funds
(Kosowski, Naik and Teo (2007)), (2) hedge funds with lockup restrictions earn higher returns
than non-lockup funds, suggesting that lockup funds provide a share illiquidity premium to
investors by efficiently managing illiquid assets (Aragon (2007)), (3) hedge funds with greater
managerial incentives provide superior performance (Agarwal, Daniel and Naik (2007)), and (4)
funds-of-funds large enough to absorb the high cost of due diligence perform better than smaller
funds-of-funds because effective due diligence excludes hedge funds likely to do poorly or fail
due to operational risk concerns (Brown, Fraser and Liang (2008)). I provide evidence that funds
with high failure risk earn substantially lower future returns than funds with low failure risk in
5
the hedge fund industry, and find that the negative failure risk effect on future fund returns is not
The rest of the paper is organized as follows. Section 2 describes the data, shows how a
typical hedge fund fails, and proposes the covariates included in a failure prediction model.
Section 3 models a fund’s probability of failure using a dynamic logit regression and reports the
regression results for the full sample. Section 4 shows the out-of-sample predictability of the
failure prediction model based on a rolling-window approach, examines whether a fund’s failure
probability is helpful to predict the fund’s future returns, and conducts several robustness checks.
Section 5 confirms the findings of the existing literature and examines whether the negative
failure risk effect on future fund returns is subsumed by the findings of the prior literature using
2. Data
In this paper, I employ the Lipper/TASS database (hereafter, TASS) 5 that provides
monthly returns, monthly assets under management (AUM), and several fund characteristics at
the individual fund level. The sample period is January 1994 to September 2007.
There are two major biases documented in the hedge fund literature. First, a survivorship
bias naturally occurs if a sample includes only live funds although the true population should
include both live and defunct (so-called dead) funds. TASS maintains two separate databases:
Live and Graveyard databases. Hedge funds that are in the Live database are considered to be
5
Liang (2000) shows that TASS provides more accurate data than the main alternative data source, HFR.
6
live funds. Once a hedge fund stops reporting to the database, the fund is transferred into the
Graveyard database and is considered to be a defunct fund. Since TASS created the Graveyard
database in 1994, my sample period starts from January 1994 in order to be free of survivorship
bias.6 Second, the backfill bias is another problem when we study hedge funds. The bias can
occur because a large number of hedge funds enter a database with a nice past performance
history to attract potential investors. Since backfilled returns tend to be overstated and could not
For further data screening, funds are dropped if they do not report net-of-fee (versus
gross) returns, do not report monthly (versus quarterly) returns, or do not report returns and
assets under management in US dollars. I also require each fund to have at least 13-month
consecutive return history during the sample period. In terms of style, I focus on individual
hedge funds8 by excluding CTAs, funds-of-funds, and funds whose style is undefined. Finally, I
exclude funds that do not report their asset size (AUM) information. If a fund’s AUM is missing
in month t, I replace it by its most recent available AUM information until month t-1. This does
not create an econometric problem because information at time t-1 is still available at time t.
After the screening procedure, I have 159,643 fund-month observations based on 3,422
hedge funds. Among them, 1,597 funds are live as of September 2007, and the remaining 1,825
funds are considered defunct. TASS assigns one of the following seven drop reasons to each
defunct fund: (1) liquidated, (2) no longer reporting to TASS, (3) TASS has been unable to
contact the manager for updated information, (4) closed to new investment, (5) merged into
6
For more detailed analysis on survivorship bias in the hedge fund literature, see Ackermann, McEnally and
Ravenscraft (1999), Brown, Goetzmann and Ibbotson (1999), Fung and Hsieh (2000), Liang (2000), Amin and Kat
(2003), and others.
7
TASS has an advantage to study backfill bias because it records the date on which a hedge fund enters the
database. Malkiel and Saha (2005) and Ibbotson and Peng (2005) report the backfill bias is about 4~5% per year.
8
TASS provides each fund’s style information based on its main trading strategy. There are 13 styles: convertible
arbitrage, dedicated short bias, emerging markets, equity market neutral, event driven, fixed income arbitrage, global
macro, long/short equity hedge, managed futures, multi-strategy, CTA, fund-of-funds, and undefined.
7
another entity, (6) dormant, and (7) unknown. In my sample, 765 funds are liquidated and the
remaining 1,060 defunct funds have one of the other six drop reasons. Although it may seem
reasonable to focus on liquidated funds for studying hedge fund failures, the prior literature
suggests that liquidation does not necessarily mean failure (Liang and Park (2008)) and a part of
the other defunct funds should be considered as failures (Baquero, et al. (2005), Fung, Hsieh,
Naik and Ramadorai (2008), and Liang and Park (2008)). However, the prior studies decide
whether a defunct fund is a failure based on the fund’s return and asset size information over the
last year, which can potentially create a look-ahead bias when forecasting fund failures. Thus, I
take a conservative approach by considering two different definitions of failures: first, failure
means liquidation, and second, failure means all of the seven drop reasons. Getmansky, Lo and
Mei (2004) also argue that using the entire Graveyard database may be more informative because
A few well-known examples of hedge fund failures such as the debacles of LTCM and
Amaranth suggest that hedge funds may fail by a sudden crash. However, it is an empirical
question whether a typical hedge fund fails suddenly or slowly. The easiest way to examine this
question is to plot the time-series history of the average return and fund flow of failed funds until
they fail. Figure 1 illustrates graphically how a typical hedge fund fails. Failure means
liquidation in Panel A, and it means all defunct cases in Panel B. Interestingly, a typical hedge
fund fails slowly. In particular, capital outflows appear to begin about one year before the
average hedge fund fails. In addition, the finding of slow failure is not sensitive to how failure is
defined.
8
I address several concerns about the slow hedge fund failure. The first concern is that the
slow failure may be driven by long share restriction (both lockup and redemption notice) periods.
The fund failure may look gradual due to a long share restriction period even though it would
have failed suddenly without such a restriction. Thus, I construct a sub-sample (18~24% of the
full sample depending on failure definition) of failed funds that do not require any lockup and
redemption notice period. This sub-sample should suffer the least from the concern. Figure 1
shows that even hedge funds with the highest share liquidity also fail slowly.
The second concern is that it may be possible to see the slow failure if hedge funds drop
out in their fiscal year-end months. Since a hedge fund manager can voluntarily stop reporting to
the database, the fund manager has an incentive to wait until the end of its fiscal year and collect
fees. The behavior can make us see the slow failure even if the fund had a bad event several
months before it fails. To mitigate the concern, I construct a sub-sample (85~87% of the full
sample depending on failure definition) of hedge funds that fail in a month that is not their fiscal
year-end month. Figure 1 shows that those hedge funds also experience slow failure.
The third concern is that slow failure may be driven simply by averaging the returns and
fund flows of failed funds. The distribution of returns and fund flows may contain a large
number of extreme values, but the plot looks gradual by averaging them. Hence, I display the
distribution of returns and fund flows of failed funds at several different points in time until they
fail. Figure 2 shows that each histogram is mostly concentrated around its average value, which
suggests that the plots of the slow failure are not driven by averaging extreme values.
9
2.3. Variables Included in a Failure Prediction Model
Given the slow failure, hedge fund failures are likely to be predictable. I therefore
investigate what kinds of fund characteristics affect hedge fund failures. The selection of
variables included in a failure prediction model is based on prior studies and economic intuition.
Prior research documents that past poor performance is a main reason for hedge fund
failures (Liang (2000), Brown, et al. (2001), Baquero, et al. (2005), and Grecu, et al. (2007)). If
hedge funds typically fail by a sudden crash, they are likely to outperform before their failures if
there is a reward to taking crash risks. In other words, the sudden crash argument suggests that
past good performance could be associated with hedge fund failures. However, section 2.2 shows
hedge funds fail slowly. Thus, I expect past poor performance to increase failure probability.
Since one month return can be a noisy predictor, I use an average of raw (net-of-fee) returns over
the prior 6 or 12 months to measure the past performance. By taking a geometric mean, I
compute the actual average performance of each fund over the period. For each fund in month t,
12
Ret[t - 12, t - 1] = 12 ∏ ( 1+ Rett -k ) - 1
k=1
. (1)
12
Ret[t - 12, t -7] = 6
∏ (1+ Ret ) - 1
k=7
t-k
A fund’s poor performance also makes it distant from the high water mark (HWM). Thus, the
fund manager may take less effort to improve the fund’s performance since he has little chance
to receive performance fees. As a result, the fund may fail (Chakraborty and Ray (2008)).9
9
In unreported analysis, I also explored the distance-to-HWM variable (return-to-HWM) as defined in Chakraborty
and Ray (2008). Consistent with their findings, the probability of hedge fund failure is higher as higher returns are
required to hit the HWM. However, the marginal impact of the distance-to-HWM variable on failure probability is
economically and statistically insignificant after controlling for past performance and past fund flows.
10
If a fund has lost its value for a long period of time, its investors may lose their patience
and start withdrawing their funds that can trigger the fund’s failure. For each fund and in each
month, investor impatience is measured by the time distance between the month in which a fund
achieves its maximum value and current month. I assume that a fund’s value is 1 when it enters
in the TASS database and its value changes by its monthly net-of-fee returns. Suppose a fund
entered the database in month t and its returns were 10% in month t+1 and -5% in month t+2.
Then, its values will be 1 × (1+0.1) = 1.1 in month t+1 and subsequently, 1.1 × (1-0.05) = 1.045
in month t+2. In each month, a fund’s maximum value is chosen among the prior 24 monthly
values. Suppose a fund just reported its return in month t and it achieved the largest value in
month t-24 and its second largest value in month t-23. Then, in month t-24, I define the investor
month t-1, investor impatience becomes 24 months. In month t, the fund’s maximum value
becomes its value in month t-23, instead of its value in month t-24, since I choose its maximum
value among the prior 24 monthly values. However, the investor impatience measure in month t
increases to 25 months because the fund’s value in month t is not a new maximum, which means
most of the investors in the fund have lost their money over a long period of time. Only when the
fund’s value in a future month becomes a new maximum, the investor impatience measure
reverses to 1 month. This investor impatience measure essentially captures how long a fund has
been down from its recent maximum value, thus how long a representative investor of the fund
has to wait until the fund comes back to its recent high. Given the slow failure of hedge funds, I
expect higher investor impatience (i.e. longer time distance) to increase failure probability.
Fund flows may affect hedge fund failures. If the investors significantly pull out their
capital following poor performance, it may require the fund to unwind some positions, which can
11
subsequently lead them to close the fund because the fund becomes too small to operate
profitably. Among the literature to study hedge fund failures, only Getmansky (2005) and Chan,
et al. (2006) examine the flow effect on fund failures. Recently, Fung, et al. (2008) document
that beta-only funds that experience below-median capital inflows are more likely to be
liquidated in subsequent two years. Following Sirri and Tufano (1998)’s study of the
performance-flow relationship in mutual funds, the monthly fund flow of each fund in month t is
measured as follows:
If a fund’s AUM is missing in month t, I assume that there is no fund flow during the month. To
mitigate the effect of extreme outliers, I truncate the monthly fund flow variable at 0.1 and 99.9
1
Flow[t - 12, t - 1] = ( Flowt -1 + Flowt-2 + ... + Flowt -12 )
12
. (3)
1
Flow[t - 12, t -7] = ( Flowt-7 + Flowt-8 + ... + Flowt-12 )
6
A hedge fund’s missing information may provide information on its failure risk. Suppose
a fund reported its monthly returns and assets under management (AUM) over a period of time,
but it suddenly provides only a part of the full information. In particular, if the fund does not
fully reveal its monthly AUM, it may signal that the investors of the fund withdraw a significant
amount of their capital and the fund hides the worsening situation. Thus, the fact that a fund does
not report its AUM information may be associated with higher failure probability. In my sample,
10
The monthly fund flows at 0.1 and 99.9 percentiles are -80% and 303%, respectively.
12
I do not find any missing return. However, about 12% of fund-month observations in my sample
contain missing AUM before replacing each missing AUM by the most recently available prior
AUM as described in section 2.1. Thus, I separately create a variable that indicates whether a
fund’s AUM reported in month t is missing. The indicator (MissAUM = 1 if a fund does not
report AUM in a month, 0 otherwise) allows me to compute the average rate that a fund does not
1
Avg # of Missing AUM[t - 12, t - 1] = ( MissAUM t-1 + ... + MissAUM t-12 )
12
. (4)
1
Avg # of Missing AUM[t - 12, t -7] = ( MissAUM t -7 + ... + MissAUM t-12 )
6
Since a fund’s higher missing rate implies that the fund hides its recent fund flows, it is expected
Fund size can also affect hedge fund failures. Some strategies have high fixed costs, so
they are not profitable on a small scale. Thus, larger funds may be more profitable, hence they
have less failure risk. Alternatively, hedge funds may stop reporting to a database when they
acquire too much capital that can limit their future profit opportunities due to capacity constraints
and hence they choose to become closed to new investors. Grecu, et al. (2007) tests the
hypothesis and provides evidence that fund size is negatively related to failure risk. Thus, I
expect larger funds to have lower failure probability. Fund size is measured by monthly assets
Other things being equal, a more volatile fund has a higher chance of extremely low
returns, which can be associated with a higher failure probability. Unfortunately, it is difficult to
accurately measure the volatility of hedge fund returns because only low-frequency (monthly)
returns are available at the individual fund level. Given the limitations of the data, I compute the
13
standard deviation of monthly raw returns over the prior 6 or 12 months to proxy for the
A fund’s age may be related to failure risk. Brown, et al. (2001) examines a linear
relation and finds old funds have lower failure risk than young funds because old funds take less
risk and pursue more sustainable strategies. Baquero, et al. (2005) find a nonlinear relationship in
that a fund’s failure risk increases up to a certain age, and subsequently starts to drop once it
survives the threshold. Since the linear relation is a special case of the nonlinear relation, I
examine a nonlinear relation between a fund’s age and its failure probability. The age variable is
I also examine how static fund characteristic variables may affect fund failures. First, I
consider two share restriction variables: redemption notice and lockup periods. Both restrictions
provide hedge fund managers higher flexibility to engage in long-term arbitrage opportunities. If
a fund does not have any share restriction, the investors may withdraw capital immediately
following poor performance, which can lead to asset fire sales. In contrast, a longer share
restriction period can attenuate the impact of such a threat. As a result, share restrictions can
lower failure risk. Between two share restriction variables, I expect the impact of redemption
notice periods on failure risk to be larger than that of lockup periods on failure risk. This is
because lockup periods affect mostly the withdrawal of initial capital, but redemption notice
periods affect investors at any time. Using similar arguments, the recent literature documents that
share restrictions have significant effects on the performance and the flow-performance relation
of individual hedge funds (Aragon (2007), Agarwal, et al. (2007), and Ding, Getmansky, Liang
14
Second, managerial incentives may affect hedge fund failures. If a fund manager’s own
capital is invested in the fund, the interest of the manager will be more aligned with that of
investors. As a result, the manager may pursue more sustainable and lower failure risk strategies.
In theory, Kouwenberg and Ziemba (2007) show that a fund manager’s risk taking is reduced
considerably if the manager’s own investment in the fund is substantial. Although I cannot
directly measure the proportion of a manager’s own capital in the fund, I include an indicator
variable (Personal Capital) to denote whether a fund’s principals have their own capital
invested.
A brief summary of the covariates for the failure prediction model is as follows: Ret[t-m,
t-k] (geometric average of monthly net-of-fee returns over the period [t-m, t-k]), Investor
Impatience[t-k] (number of months, measured in month t-k, since a fund achieves its maximum
value), Flow[t-m, t-k] (simple average of monthly fund flows over [t-m, t-k]), Avg # of Missing
AUM[t-m, t-k] (average number of months, expressed in percents, that a fund’s assets under
management (AUM) is missing over [t-m, t-k]), Size[t-k] (a fund’s assets under management in
month t-k), Volatility[t-m, t-k] (standard deviation of monthly returns over [t-m, t-k]), Age[t]
(number of months, measured in month t, since a fund enters TASS), Redemption Notice Period
(in months), Lockup Period (in months), and Personal Capital (1 if principals have money
invested, 0 otherwise).
I consider two types of covariates: time-varying covariates and constant covariates. Time-
varying covariates include Ret[t-m, t-k], Investor Impatience[t-k], Flow[t-m, t-k], Avg # of
Missing AUM[t-m, t-k], Size[t-k], Volatility[t-m, t-k], and Age[t]. Constant covariates are share
restriction periods (Redemption Notice Period and Lockup Period) and the presence of
15
managerial ownership (Personal Capital). For several time-varying covariates, I explore
different measurement periods in each month t: for example, [t-6, t-1], [t-12, t-7], and [t-24, t-
13].11 For investor impatience and fund size variables, I explore two lagged periods: t-1 and t-7.
By exploring several information lags, I can examine whether hedge fund failures can be
predicted by very recent (1-month lagged) information as well as by older (7-month or 13-month
lagged) information. If fund failures are predicted by the old information, the results will be
consistent with the slow failure model. After excluding missing observations, the sample based
on 1-month lagged variables contains 134,461 fund-month observations that include 3,421 hedge
funds (1,596 live and 1,825 defunct funds) where 765 funds are liquidated.
Table 1 reports the summary statistics of the variables based on the full sample (Panel A)
and within each fund-month group (live, liquidation, and other defunct fund-month observations)
of the sample (Panel B). Thus, a failed fund’s non-failure-month observations are treated as live
fund-month observations in Panel B. I report the summary statistics in this way because only
failure-month observation of a failed fund is treated as a failure event when I model the failure
probability of hedge funds. Panel A reports the average characteristics of the hedge fund
industry. Imagine that we observe a typical hedge fund’s 7-month lagged information in month t.
The fund provides 0.74% average monthly net-of-fee returns. It has been down from a recent
maximum value for about 5.6 months. It acquires 2.1% monthly new capital from investors.
About 8% (= 0.48 month) of the prior 6 monthly AUM is missing. Its AUM is about 156
millions in US dollars. Its return volatility is 3.28% per month. About 32 (= 39-7) months have
passed since it starts reporting to TASS. Its share restriction period is 5 months (= 1.2 months of
11
I also explore the measurement period, [t-12, t-1], which is the main measurement period when I describe as 1-
month lagged failure prediction model in later sections. For simplicity, I do not report summary statistics based on
the measurement period. Further, to measure the time-varying covariates, I require at least 6 consecutively non-
missing observations for the periods, [t-12, t-1] and [t-24, t-13], and at least 3 consecutively non-missing
observations for the period [t-12, t-7].
16
redemption notice period + 3.8 months of lockup period). Finally, there is a 50% chance that the
lower than that of non-failure-month observations. When failure means liquidation (other defunct
reasons), the average return of failure months is -0.58% (-0.13%) per month over the period [t-6,
t-1]. Over the same period, the average return of non-failure months is 0.71% per month. Thus,
the average monthly return difference can be as large as 1.29% over the period. The results also
suggest that liquidation defines failure better than other drop reasons. In addition, the average
return difference between liquidation months and non-failure months is 0.86% (= 0.75%-(-
0.11%)) per month over the period [t-12, t-7] and 0.53% (= 0.79%-0.26%) per month over the
period [t-24, t-13]. The results suggest that liquidated funds have experienced poor performance
compared to their peers for a long period of time, which is generally consistent with the slow
failure model. Further, the investor impatience measure also supports for the slow failure model.
Even 7-month before a typical fund’s liquidation, the fund has been down from its recent
maximum value for about 8.9 months, which is much longer than 5.6 months of non-failure
observations. Thus, investor impatience could be very high even at that point (7-month before
liquidation). As a result, even long-term investors may start pulling out their money from the
fund. Past fund flow information is largely consistent with the story. The average monthly fund
flow of a typical liquidated fund is 1.91% over the period [t-24, t-13]. However, the fund
experiences net outflows (-0.98% per month) over [t-12, t-7], and subsequently, the fund
outflows become extremely large (-3.02% per month) over [t-6, t-1]. Moreover, a typical
liquidated fund shows an increasing tendency not to report its monthly AUM information as the
fund approaches its failure event. Since we may expect that a fund does not report AUM in order
17
to hide a worsening fund outflow situation, it is reasonable to assume that the missing AUM
information is more likely to be associated with fund outflows. From this perspective, the fund
outflow effect on fund failures in this paper can be viewed as a lower bound. If every fund fully
revealed its flow information, we can expect to see a larger flow effect on fund failures. For
other fund characteristic variables, liquidation is more likely to be associated with a smaller
capital amount, slightly higher volatility, younger funds, shorter share restriction periods, and
In section 2.3, I propose the covariates to be included in a failure prediction model based
on prior literature and economic intuition. In this section, I explain why a dynamic logit model is
preferable to alternative failure prediction models and provide the econometric specification of
Shumway (2001) suggests that researchers should use a hazard model, instead of using a
single-period static model, for the purpose of forecasting corporate bankruptcies because static
models produce biased and inconsistent estimates by ignoring the fact that firms change through
time. The same argument should apply for modeling hedge fund failures. Shumway (2001) also
shows that the hazard model can be easily estimated using a maximum likelihood estimation
technique based on a logit estimation program.12 Recently, Chava and Jarrow (2004), Bharath
and Shumway (2008), and Campbell, et al. (2008) builds on the Shumway model to forecast
12
Shumway (2001) shows that a multi-period (dynamic) logit model is equivalent to a discrete-time hazard model.
18
corporate bankruptcies and failures. The previous hedge fund literature also uses a semi-
parametric Cox (1972) proportional hazard rate model to predict hedge fund failures (Brown, et
al. (2001), Rouah (2005), Grecu, et al. (2007), and Liang and Park (2008)). The Cox model has
an advantage because of the flexible non-parametric estimation of baseline hazard function. For
my purpose that requires estimating the calendar-time failure probability of individual funds, the
dynamic logit model is preferable to the Cox model because the Cox model is an event-time
analysis based on each fund’s lifetime duration data. However, as Shumway (2001) provides a
theoretical argument and Brown, et al. (2001) provides empirical evidence, the directional effect
of a certain covariate on failure probability should be robust to the choice of a failure prediction
model between a parametric dynamic logit regression and a semi-parametric Cox proportional
Since I model the failure probability of hedge funds using a dynamic logit regression, the
⎛M ⎞
exp ⎜ ∑ xi , j , t − k β j ⎟
Pr ( yi , t = 1) = ⎝ j =1 ⎠ , (5)
⎛ M ⎞
1 + exp ⎜ ∑ xi , j , t − k β j ⎟
⎝ j =1 ⎠
where yi , t is an indicator that takes 1 if a fund i fails in month t, xi , j , t − k is a fund i’s covariate j’s
value measured in month t-k, and β j measures how a covariate j affects failure probability. In
terms of the interpretation of estimated parameter values, a positive (negative) β j implies that
the covariate j increases (decreases) failure probability. By allowing for different lagged
information (different k-values), I examine whether fund failures are predicted by very recent (1-
19
In addition to the variables described in table 1, I consider I(Ret[t-m, t-k]<0) (1 if Ret[t-
otherwise) to examine how negative average return and fund outflow affect fund failures beyond
the effects of average return and average fund flow on failure probability. Among the covariates,
Investor Impatience, Size, Age, and Lockup Period are log-transformed before entering in a
regression model. For the age variable, I also include squared age to capture a potential nonlinear
relation between hedge funds’ age and their failure probability. Further, I control for two
calendar-time effects. First, hedge funds may drop out more in their fiscal year-end months
because of at least two reasons: a fund’s manager has an incentive to wait until its fiscal year-end
date and collect fees, and its auditors may detect the problem of the fund. Since most fiscal year-
end months are found in December13, I include a December dummy variable (Dec) to control for
the fiscal year-end effect on failure probability. Second, year variable (Year) is included to
control for a trend of hedge fund failures over time. Finally, a set of style dummies are included,
where each style effect on hedge fund failures is relative to the effects of the other styles
In Table 2 (Table 3), I examine how 1-month (7-month) lagged covariates affect failure
probability. In Panel A of each table, failure means liquidation. In Panel B, failure means all
defunct cases including liquidation. Since there are many reasons that a fund stops reporting to
13
A more direct way to control for the fiscal year-end effect is to include a dummy variable for a fund’s fiscal year-
end month. Unfortunately, about 27% of the sample does not have information on the fiscal year-end month. Within
the remaining sample, about 85% reports that December is their fiscal year-end month. Thus, I use a December
dummy variable to increase the sample size as well as to keep the fiscal year-end effect.
20
the database and some of them are not clearly related to failure, I examine whether the results are
In each regression, I report both statistical and economic significance. For the statistical
significance, I take account of the critique of Petersen (2007) that the estimated standard errors
of panel-regression parameters are downward biased (as a result, t-values are overstated) when
researchers treat the panel observations as independent in the presence of firm effect. Hence, I
compute t-values using the standard errors clustered by fund. For the economic significance, the
marginal effect of each variable is computed as the change in failure probability expressed in
percents when a continuous variable increases by one standard deviation at its mean value or a
In Table 2, I focus on the interpretation of the results for the Model 1 in Panel A. The
marginal effect of each covariate is based on the benchmark failure probability, 0.57% (=
765/134,461) per month. The sign of each estimated parameter is largely consistent with the
expectation described in section 2.3. First, poor performance increases failure risk. Other things
being equal, a one standard deviation decrease of Ret[t-12, t-1] increases the failure probability
from 0.57% to 0.69% by 0.12% per month. In addition, if a fund’s average return over the last
year is negative (I(Ret[t-12, t-1]<0)), it increases the failure probability by 0.26%. Second, a
fund’s situation that it has been under its recent maximum value over a long period of time
increases failure risk. A one standard deviation increase of the investor impatience measure
increases the failure probability by 0.09%. Third, fund withdrawals by investors increase failure
risk. If a fund’s inflow, Flow[t-12, t-1], drops by one standard deviation, its failure probability
increases by 0.21%. In addition, if investors typically withdraw their funds over the period
(I(Flow[t-12, t-1]<0)), the fund’s failure probability increases by 0.20%. Fourth, the higher rate
21
of missing AUM increases failure risk. If the average missing rate increases by one standard
deviation, the failure probability increases by 0.11%. Since we may expect that a fund does not
fully report its AUM in order to hide a worsening fund outflow situation, the effect of missing
AUM ratios on failure risk can be viewed as additional fund outflow effect on fund failures.
Fifth, smaller fund size increases failure risk. The failure probability increases by 0.30% if a
fund’s size decreases by one standard deviation. Sixth, higher volatility appears to decrease
failure risk. Although the result is not intuitive, it is consistent with the recent literature
documenting that volatility does not capture the downside risk of hedge funds (e.g. Liang and
Park (2008)). Seventh, I find an inverse U-shaped relation between fund age and failure risk.
Failure risk increases as a fund’s age grows up to a certain point (about 3 years since a fund
enters to the database), but failure risk starts to decrease if a fund survives the threshold. The
nonlinear relationship is consistent with the finding of Baquero, et al. (2005) in the hedge fund
literature and that of Lunde, Timmermann and Blake (1999) in the mutual fund literature.
Several constant covariates also affect failure risk. First, longer share restriction (both
redemption notice and lockup) periods decrease failure risk. In fact, the redemption notice period
has a stronger effect on failure risk than the lockup period. A one standard deviation increase of
the redemption notice period lowers the benchmark failure probability by 0.13% per month, but
an increase of the lockup period lowers the failure probability by 0.07%. This may be because
the lockup period affects mostly early capital withdrawal, but the redemption notice period can
affect investors’ capital withdrawal anytime during a fund’s life. Second, the presence of
managerial ownership is associated with lower failure risk.14 Funds with managerial ownership
have 0.14% per month lower failure probability than those without managerial ownership.
14
My exposition in this paper is based on the hypothesis that higher managerial ownership reduces an agency cost
between fund manager and shareholders, hence it lowers failure risk. Alternatively, a fund manager could withdraw
22
In Model 2, I examine whether extremely negative returns or extreme fund outflows
typically trigger fund failures. For the purpose, I include the interaction of I(Ret[t-12, t-1]<0)
and squared Ret[t-12, t-1] and the interaction of I(Flow[t-12, t-1]<0) and squared Flow[t-12, t-1]
to capture the potential nonlinear effects of extreme negative returns and extreme fund outflows
on fund failures.15 If the parameter coefficients of the two interaction terms are positive and
statistically significant, then we can argue that extremely negative returns and extreme fund
outflows increase failure probability. But, the results show that both interaction terms are
statistically insignificant and one of the interaction terms is a negative sign, suggesting that a
typical hedge fund failure is not driven by extremely negative returns or extreme fund outflows.
In Model 3, I examine whether past performance and fund flows measured in month t-13
provide additional failure predictability beyond the covariate effects measured in month t-1. The
effects of two performance variables, Ret[t-24, t-13] and I(Ret[t-24, t-13]<0), are statistically
insignificant although the estimated signs are correct. For the flow-related variables, the sign of
one variable, Flow[t-24, t-13], is the opposite although the other variable, I(Flow[t-24, t-13]<0),
shows a significant effect. Thus, the results suggest that the 13-month lagged performance and
In Table 3, I divide the main measurement period, [t-12, t-1], of the previous table into
two separate periods, [t-12, t-7] and [t-6, t-1], in order to examine whether a fund’s failure in
month t is predicted by the covariates measured in month t-7. The results from Model 1 are
consistent with the slow failure model in that the time-varying covariates (past performance,
his/her own capital since he/she expects the fund to fail in the near future. Thus, I do not highlight any causality
issue between managerial ownership and failure risk. Given the limitation of data that the presence of managerial
ownership is a constant variable, it is difficult to make a strong inference on the causality issue.
15
Since I already include a second-order moment variable (volatility) in the failure prediction model, the effect of
average second-moment value on failure risk is controlled. Thus, I do not consider the squared terms (squared Ret[t-
12, t-1] and squared Flow[t-12, t-1]) by themselves. Further, I also explored how higher order moments (skewness
and kurtosis) of monthly returns affect failure probability, and found the marginal impacts of higher order moments
on failure risk are insignificant.
23
investor impatience, fund flows, fund size, etc.) measured in month t-7 affect significantly fund
failures in month t. In Model 2, I examine whether past performance and fund flows measured in
month t-7 provide additional failure predictability beyond the covariate effects measured in
month t-1. The results are generally consistent with the slow failure model. First, the four
measures of past performance and past fund flows enter in the regression with the expected
signs. Poor past performance and smaller fund inflows (or fund outflows) measured in month t-7
are helpful to predict fund failures in month t over and beyond the effects of covariates measured
in month t-1. Second, two of the four variables, I(Ret[t-12, t-7]<0) and Flow[t-12, t-7], are
statistically significant. Since past performance and fund flows measured over [t-6, t-1] are also
affected by the variables measured over [t-12, t-7], the statistical significance results should be
interpreted as evidence for the slow failure model. Therefore, hedge fund failures are well
predicted by even 7-month lagged performance and fund flow information. Moreover, the overall
results of Panel B in Table 2 and 3 suggest that our understanding for the failure prediction
In this section, I examine how the predicted (ex ante) failure probability of hedge funds is
related to their future performance. In order to obtain the ex ante failure probability measure, I
estimate the failure prediction model every month using a rolling-window approach based on
only prior information, instead of using the parameter estimates obtained from the full-sample
results. I highlight that the predicted failure probability is the ex ante measure because (1) the ex
24
ante measure avoids any potential look-ahead bias, (2) it allows me to examine an out-of-sample
I consider two failure prediction models: first, when failures are predicted by 1-month
lagged information (Model 1 in Table 2) and second, when failures are predicted by 7-month
lagged information (Model 1 in Table 3). In each case, I exclude the Year variable because I use
a rolling-window approach that intrinsically takes account of a calendar time effect. Specifically,
in each month t-1 since December 1995 (or June 1996), failures are predicted by 1-month (or 7-
month) lagged covariates using the prior two-year observations. At the beginning of month t
starting from January 1996 (or July 1996), I estimate the failure probability of hedge funds using
both the model’s parameter estimates and the covariate values in month t-1 (or month t-7):
⎛M ⎞
exp ⎜ ∑ xi , j , t − k βˆ j , t − k ⎟
( Predicted ) Failure Probabilityi, t = ⎝ j =1 ⎠ , where k = 1 or 7 , (6)
⎛ M ⎞
1 + exp ⎜ ∑ xi , j , t − k βˆ j , t − k ⎟
⎝ j =1 ⎠
xi , j , t − k is a fund i’s covariate j’s value observed in month t-k and βˆ j , t − k is a covariate j’s
parameter estimate based on k-month lagged information. It is important to note that the
predicted failure probability measure is based on only past information. At the beginning of each
month starting from January 1996 (or July 1996), I sort individual funds into quintiles by the
Since I group hedge funds into quintiles based on the ex ante measure, I can examine the
out-of-sample predictability of the failure prediction model. If the model can classify hedge
funds well out-of-sample, a higher failure risk quintile will contain more failed funds than a
lower failure risk quintile. Since the average performance of failed funds tends to be poorer than
that of live funds, we may expect the future performance of a higher failure risk quintile to be
25
poorer. Table 4 reports the out-of-sample predictability. Overall, the failure prediction model has
good out-of-sample predictability and the number of failed funds in each quintile increases as
failure risk increases. In Panel A-1 where failures are predicted by 1-month lagged information,
476 funds (62.9%) out of 757 liquidation funds are classified in the highest failure risk quintile,
but only 25 funds (3.3%) are classified in the lowest failure risk quintile. In Panel B-1 where
failures are predicted by 7-month lagged information, 376 funds (50.0%) out of 752 liquidation
funds are classified in the highest failure risk quintile, but only 35 funds (4.7%) are classified in
the lowest failure risk quintile. Panel A-2 and Panel B-2 show similarly good out-of-sample
Table 5 reports the average characteristics across quintiles. Overall, the highest failure
risk quintile has negative past performance, has the highest investor impatience, experiences
capital outflows, has the highest rate of missing AUM, has the smallest fund size, takes the
highest volatility risk, requires the shortest share restriction periods, and has the lowest presence
information and failure means liquidation (Panel B-1), the highest failure risk quintile is
characterized by -0.24% monthly average return over [t-12, t-7]. The average fund in the highest
failure risk quintile has been down from a recent maximum value for about 10 months even in
month t-7. It loses capital on average 1.87% per month over [t-12, t-7] on top of the reduction of
its asset values. About 10.6% (= 0.64 months) of 6 monthly AUM information over [t-12, t-7] is
missing for the highest failure risk quintile. Its AUM in month t-7 is about 30.7 millions in US
dollars. Its return volatility over [t-12, t-7] is 3.48% per month. About 31 (= 38-7) months have
passed in month t-7 since the average fund in the highest failure risk quintile starts reporting to
TASS. The average share restriction period of the highest failure risk quintile is 2.45 months (=
26
0.77 months of redemption notice period + 1.68 months of lockup period). There is a 37%
chance that the average fund manager in the highest failure risk quintile invests his/her own
capital in the fund. Finally, the average failure probability of the highest failure risk quintile
After sorting individual funds into quintiles based on the predicted failure probability at
the beginning of each month, I measure the equally-weighted16 portfolio return of each quintile
during the month. As a result, I obtain the monthly time-series of each quintile portfolio returns
from January 1996 (when failures are predicted by 1-month lagged covariates) or July 1996
common risk factors. The three factors of Fama and French (1993) are typically used in the stock
market and mutual fund literature. However, the three factors are not enough for hedge funds
because they hold broader asset classes than mutual funds and they also create nonlinear payoffs
by using high leverage, derivatives, and short sales. Fung and Hsieh (1997, 2001), Mitchell and
Pulvino (2001), and Agarwal and Naik (2004) show that hedge fund returns have option-like
properties due to their trading strategies. Building on the literature, Fung and Hsieh (2004)
propose a seven factor model. Their seven factors include three primitive trend-following (or
(PTFCOM)17. The other four factors are two of the Fama-French three factors and two bond
16
I also compute value-weighted returns (using a fund’s size in month t-1 as a weight) and find similar results. For
simplicity, I do not report the results based on value-weighted returns.
17
Fung and Hsieh (2001) explain the construction of trend-following factors in detail. Also, trend following factors
are available at http://faculty.fuqua.duke.edu/~dah7/DataLibrary/TF-FAC.xls.
27
factors: excess market returns (CRSP value-weighted returns minus 1-month T-bill rates)
(MKTRF), size factor (small cap minus big cap) (SMB)18, change in credit spreads (Moody's Baa
yield minus 10-year treasury yield) (∆DEF), and change in 10-year treasury yields (∆Y10)19. The
recent literature uses the seven factor model for measuring risk-adjusted returns and conducting
performance tests (e.g. Kosowski, et al. (2007) and Fung, et al. (2008)).
In addition to Fung and Hsieh’s seven factors, I consider two well-known factors, book-
to-market factor (HML) and Carhart (1997)’s momentum factor (UMD)20. Finally, I include two
(1-month and 2-month) lagged excess market returns based on the following literature. Asness,
Krail and Liew (2001) find the market exposure of hedge fund returns is underestimated in a
regression using only contemporaneous market returns because many hedge funds hold illiquid
or hard-to-price assets that often create non-synchronous returns. They show hedge funds’ betas
increase after including lagged market returns in the regression. Similarly, Getmansky, Lo and
Makarov (2004) and Getmansky, et al. (2004) model the monthly reported (observable) returns
of hedge funds as an MA(2) process of true (unobservable) returns. If we believe that true returns
co-move with observable market factors, the smoothing effect of reported returns can be
mitigated by including lagged market returns in a time-series regression. Therefore, I run the
where ri , t is the excess returns of quintile portfolio i in month t, and α i measures the average
18
Fung and Hsieh (2004) originally use S&P 500 index returns and Wilshire small cap minus large cap returns
instead of CRSP value-weighted returns and Fama-French’s SMB factor, respectively.
19
I obtain Moody’s Baa yields and 10-year treasury yields from H.15 reports of Federal Reserve statistical release.
20
The Fama-French’s three factors and Carhart’s momentum factor are taken from Ken French’s website.
28
Table 6 reports the time-series regression results for quintile portfolios and zero-cost
spread portfolio (long the lowest failure risk quintile and short the highest failure risk quintile). I
focus more on the case where failures are predicted by 7-month lagged information in order to be
consistent with the slow failure model and mitigate a concern about information availability
when a trading strategy is implemented. I also consider both definitions of failure. In Panel A
(where failure means liquidation), I find that a fund’s failure probability predicts negatively the
fund’s future returns. The average return of the lowest failure risk quintile is 0.83% per month,
but that of the highest failure risk quintile is only 0.30%. Thus, the return spread between two
portfolios (or the average return of zero-cost spread portfolio) is 0.53% per month. Interestingly,
I find a larger return spread based on the failure risk after adjusting for nine risk factors and a
return smoothing effect. The large return spread is driven more by the negative alpha (-0.34%) of
the highest failure risk quintile than by the positive alpha (0.27%) of the lowest failure risk
quintile. Hence, the alpha spread is 0.61% per month (7.57% annualized) and statistically
significant (t-statistic = 5.10). In addition, the loadings on the Fama-French three factors
(MKTRF, SMB, and HML) suggest that the highest failure risk quintile has higher loadings on
stock market, small-cap stocks, and value stocks than the lowest failure risk quintile. Similarly,
in Panel B (where failure means all defunct cases), the alpha spread is 0.71% per month (8.86%
annualized) and statistically significant (t-statistic = 6.15). Hence, the negative relation between
failure risk and future performance is not sensitive to how failure is defined.
I also examine the case where failures are predicted by 1-month lagged information. In
Panel C (where failure means liquidation), I find that the alpha spread is 0.65% per month and
statistically significant as expected from the results of the failure prediction model and the out-
of-sample predictability. In this case, the momentum factor (UMD) becomes the most important
29
risk factor. The UMD factor loadings suggest that the highest failure risk quintile has the highest
loading on losing stocks. Also, Panel D shows that the results are not sensitive to how failure is
defined. Moreover, Figure 3 displays the time-series plots of monthly returns for the highest
failure risk quintile and the lowest failure risk quintile. The plots suggest that the large return
spread based on the predicted failure probability is not driven by a few months.
I address several potential concerns about the results that a fund’s failure probability
predicts negatively the fund’s future returns and the return spread based on the predicted failure
probability is large and statistically significant. The first concern is that the negative relation
between failure risk and future performance may be mostly driven by extremely negative failure
month returns. To address the concern, I remove failure month returns within each quintile
portfolio and re-run the time-series regressions as in equation (7). Table 7 reports the alphas of
quintile portfolios and zero-cost spread portfolio. Overall, the results are similar to those reported
in Table 6. In Panel A-1 (where failure means liquidation and failures are predicted by 7-month
lagged information), the alpha of the highest failure risk quintile is -0.30% per month that is
slightly higher than -0.34% in Table 6 (Panel A). Thus, the results suggest that the average
failure month return is negative, but the effect of failure month returns on the large return spread
is not material.
The second concern is that the negative relation between failure risk and future
performance may be mostly driven by extremely small funds. Previous sections suggest that
failed funds are typically smaller than surviving ones, and funds in higher failure risk quintiles
are smaller than funds in lower failure risk quintiles. Since a few well-known failed funds such
as LTCM and Amaranth are large funds, it is important to address this concern. To mitigate the
30
concern, I remove the bottom quintile (based on fund size) of the sample in each month and
repeat the analysis. Table 7 reports the alphas of quintile portfolios and zero-cost spread portfolio
based on the new sample. I still find the negative relation between failure risk and future
performance even after removing the extremely small funds although the return spreads become
The third concern is that the large return spread may be mostly driven by constant failure
predictors such as share restrictions and the presence of managerial ownership. If the constant
variables drive the return spread, it may not be strictly consistent with the slow failure model.
Thus, I consider three different specifications of the failure prediction model: failures are
predicted by (1) both time-varying and constant covariates, (2) only time-varying covariates, and
(3) only constant covariates. Further, in each specification, failures are predicted by either 7-
Table 2). In each case (out of 12 cases: 2 failure definitions, 3 failure model specifications, and 2
different lags), I estimate the failure probability using only prior information, sort all funds into
quintiles by the predicted failure probability, and examine the alphas of quintile portfolios and
zero-cost spread portfolio. Table 8 reports the alphas. The main concern is whether the
documented return spread is mainly driven by constant covariates. In fact, the concern is
legitimate since the return spreads based on the failure risk predicted by only constant variables
are large and statistically significant (Panel C). However, the return spread based on 7-month
lagged covariates is not mainly due to constant variables. When failures are predicted by 7-
month lagged time-varying covariates, the return spread is still 0.48% per month and statistically
significant (Panel B). Thus, the results suggest that both time-varying and constant failure
predictors contribute to the large return spread based on failure risk. Moreover, the return spread
31
based on failure risk becomes the largest and statistically the most significant when both time-
varying and constant covariates are included in the failure prediction model (Panel A).
4.4. Interaction Effect of Failure Risk and Share Restrictions on Hedge Fund Returns
As a hedge fund becomes concerned that investors are likely to withdraw capital due to
poor performance, it may be forced to change its investment policy. In particular, it has to take
more positions in liquid assets so that it can meet redemption requests and it has to avoid trades
that could lead to sharp losses in the short-term that would accelerate withdrawals. To become
more liquid, a fund may have to liquidate some illiquid positions, which can be costly and hence
reduce its performance. These concerns about meeting redemptions and minimizing the risk of
fund outflows are heightened for funds with weaker share restrictions. Such funds are therefore
To examine whether hedge funds with weaker share restrictions perform poorly when
their failure risk is high, I use a double-sort approach. At the beginning of each month, I sort all
funds into two groups by a share restriction variable (either the median of redemption notice
periods or the presence of a lockup provision), and then sort the funds in each group into tertiles
by their probability of failure. Table 9 reports the monthly alphas of the portfolios obtained by
the time-series regression described in equation (7), and shows that hedge funds with weaker
share restrictions earn sharply lower returns when their probability of failure is high. Even for
funds with stronger share restrictions, I still find that funds with high failure risk perform worse
than those with low failure risk. However, the results suggest that funds with weaker share
restrictions are the main sources of negative alphas for funds with high failure risk, consistent
with the hypothesis that such funds are concerned more about meeting redemptions and the
32
threat of capital withdrawals, and therefore make the funds more liquid, which can lead to a poor
5.1. How does a fund’s covariate affect the fund’s future returns?
Since failures are predicted by covariates and the estimated failure probability is a
function of covariates, it is natural to expect the negative relation between failure risk and future
performance to be associated with how a fund’s covariate affects the fund’s future returns. In
addition, prior literature documents that several covariates have a relationship with the future
performance of hedge funds. Therefore, I first confirm the findings of prior literature and
examine whether the failure risk effect on future performance is subsumed by the covariate
effects documented in the previous studies. To examine such issues, I use the cross-sectional
I first examine whether the findings of prior literature still appear in my sample. In each
month from July 1996 (or January 1996 when 1-month lagged information is used) to September
where ri , t is the excess return (over 1-month T-bill rate and multiplied by 100) of fund i in
month t, k = 7 or 1, m = 12, and Covariate j [t - k] is one of the following variables: Ret[t-m, t-k],
21
Alternatively, I also explored the time-series regression approach using the portfolios sorted by each covariate.
The main findings and implications were similar to the results based on the cross-sectional regressions. Since it is
easy to examine the effects of several variables simultaneously in the cross-sectional regression, I report the cross-
sectional regression results.
33
Investor Impatience[t-k], Flow[t-m, t-k], Avg # of Missing AUM[t-m, t-k], Size[t-k], Volatility[t-
m, t-k], Age[t], Redemption Notice Period, Dlock,22 and Personal Capital. Investor Impatience,
Size, and Age variables are log-transformed before running the regression. The Panel A of Table
9 reports the time-series average of monthly parameter estimates for each covariate and its
The results of the univariate regressions are largely consistent with the findings of prior
literature. First, current month returns are predicted by past performance (either 1-month or 7-
month lagged performance measure). On average, funds that outperform by 1% per month tend
to outperform by 0.26% in the next month and by 0.14% in the next seven months. Hence, the
results are consistent with the performance persistence literature (e.g. Agarwal and Naik (2000),
Baquero, et al. (2005), Kosowski, et al. (2007), Fung, et al. (2008), and Jagannathan, Malakhov
and Novikov (2008)). Second, higher investor impatience is associated with lower future returns.
Suppose fund A has been down from its recent maximum value for five months and fund B has
been down from its maximum value for ten months. Then, fund B’s monthly return is expected
to be lower than fund A’s monthly return by 0.17% (= 0.25% × (ln(10) – ln(5))) in the next
month and by 0.13% in the next seven months. Third, a higher average rate of missing AUM is
also associated with lower future returns. If the average rate of missing AUM increases by 16.7%
(corresponding to 1 additional monthly missing observation for the period [t-12, t-7] or 2
additional monthly missing observations for the period [t-12, t-1]), the average monthly return is
expected to decline by 0.04% (= 0.25% × (2/12)) in next month and by 0.03% (= 0.20% × (1/6))
in seven months. Fourth, funds with longer share restriction (redemption notice and lockup)
periods perform better than funds with shorter share restriction periods. Funds with lockup
22
Although a lockup period variable is continuous, I transform it to a binary variable (whether a fund has lockup
provision or not) following Aragon (2007) who finds funds with lockup provision perform better than funds without
lockup provision.
34
provision outperform those without lockup provision by 0.27~0.29% per month. The results are
consistent with the finding of Aragon (2007). Fifth, funds with managerial ownership perform
better than those without managerial ownership by 0.25~0.28% per month. The results are
consistent with Agarwal, et al. (2007) who find that greater managerial incentives are associated
Since the predicted failure probability is a function of the covariates, we should expect
the negative failure risk effect on future performance to be related to each covariate’s effect.
However, if any covariate effect subsumes the failure risk effect, the large return spread based on
failure risk would not be a new finding. To test whether the failure risk effect is subsumed by
any covariate effect, I run the following cross-sectional regression across funds in each month:
ri, t = at + b1, t FailureRisk[t - k]i + b2, t Ret[t - m, t - k]i + b3, t InvestorImpatience[t - k]i
+ b4, t Flow[t - m, t - k]i + b5, t Avg#ofMissingAUM[t - m, t - k]i + b6, t Size[t - k]i
, (9)
+ b7, tVolatility[t - m, t - k]i + b8, t Age[t]i + b9, t RedemptionNoticePeriodi
+ b10, t Dlocki + b11, t PersonalCapitali + ei, t
where ri , t is the excess return of fund i in month t, k = 7 or 1, m = 12, and Failure Risk is a rank
variable of the predicted failure probability ranging from 1 (the lowest failure risk) to 10 (the
highest failure risk) where the rank variables are created in each month.23 The Panel B of Table 9
reports the time-series average of monthly parameter estimates for each independent variable and
23
Using the predicted failure probability directly can create an errors-in-variables problem because the predicted
failure probability is measured with errors. By using the rank variable, the potential errors-in-variables problem can
be mitigated. Kisgen (2006) also uses a similar approach to reduce a potential errors-in-variables complication in his
credit score measure.
35
Overall, the negative failure risk effect on future performance is not subsumed even after
controlling for the effects of many covariates on future performance. When failures are predicted
by 7-month (or 1-month) lagged information, the average excess return of hedge funds falls by
4~5bp per month as their failure risk increases by one rank. Hence, the return spread between
two extreme ranks can be as large as 0.36~0.45% per month even after controlling for a large
number of covariates. Interestingly, the failure risk effect appears to subsume the effects of
investor impatience, the average rate of missing AUM, and share restrictions (redemption notice
period and lockup provision) on future performance. Also, the economic impact of managerial
I document that failure risk is a good return predictor and the failure risk effect subsumes
some covariate effects. However, there is a concern that my failure risk measure is based on
covariates and as a result, the failure risk effect may be driven by a specific covariate effect. To
further address the concern, I predict fund failures after dropping a specific covariate. Based on
the newly predicted failure probability and the covariate, I run a cross-sectional regression across
variable (ranging from 1 to 10) of the predicted failure probability (based on a failure prediction
model where failures are predicted excluding Covariate j [t - k] ), and Covariate j [t - k] is one of
the following variables: Ret[t-m, t-k], Investor Impatience[t-k], Redemption Notice Period,
36
Dlock, 24 and Personal Capital. I consider the five covariates because the effects of these
variables on future fund returns are stronger than those of other covariates. Table 10 reports the
time-series average of monthly parameter estimates for each independent variable and its
different lags, 2 failure definitions, and 5 covariates), the negative failure risk effect on future
fund returns is not subsumed by one of performance predictors even after excluding the covariate
when predicting fund failures and estimating failure probability. Therefore, the results suggest
6. Conclusion
In this paper, I examine how hedge funds fail, whether failure is predictable, and whether
a fund’s probability of failure is helpful to predict the fund’s future returns. On average, hedge
funds fail slowly rather than through sudden crashes. The slow failure is neither because hedge
funds require a long share restriction period nor because hedge fund managers wait until the end
of the fiscal year for collecting fees. Instead, hedge funds fail slowly as poor performance over a
period of time leads to fund withdrawals by investors while increasing their impatience. I model
a fund’s failure probability using a dynamic logit regression and find that fund failures are
predicted by past performance and fund flows measured with a lag of seven months. Overall,
past poor performance, higher investor impatience, capital outflows, higher frequency of missing
asset size, smaller fund size, shorter share restriction periods, and lower managerial ownership
24
In a failure prediction model, I drop the lockup period variable. In a cross-sectional regression, I include the Dlock
variable that indicates whether a fund uses a lockup provision. Using the lockup period variable in a cross-sectional
regression does not affect the results.
37
As a next step, I examine how the predicted (ex ante) failure risk of hedge funds affects
their future performance. Estimating the predicted failure probability measure based on a rolling-
window approach and sorting hedge funds into quintiles by the predicted failure probability
based on information lagged by seven months, I find that the return spread of the two extreme
quintiles is 7.6%~8.9% per year after adjusting for nine commonly used hedge fund risk factors
and a return smoothing effect. The large return spread is not mainly driven by either failure-
month returns or extremely small funds, suggesting that the negative impact of failure risk on
future performance is robust. Further, the return spread based on failure risk when failures are
predicted by both time-varying and constant covariates is economically larger and statistically
more significant than the return spread based on failure risk when failures are predicted by either
only time-varying covariates or only constant covariates, suggesting that the failure risk effect is
amplified by the interactions of hedge funds’ dynamic variables such as performance and fund
flows and their static variables such as share restrictions and managerial ownership. Moreover,
the negative failure risk effect on future fund returns is sharply higher for funds with weaker
share restrictions, consistent with the hypothesis that such funds are concerned more about the
threat of capital outflows, make the funds more liquid by liquidating some assets at suboptimal
times or investing more in liquid positions, and are more likely to perform poorly when their
failure risk is high. Finally, the results from various cross-sectional regressions suggest that the
negative failure risk on future fund returns is not subsumed by the findings of the prior literature.
38
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42
Table 1
Summary Statistics of Variables for a Failure Prediction Model
This table reports summary statistics of variables for a hedge fund failure prediction model. Panel A reports
summary statistics (mean, standard deviation, minimum, and maximum) of each variable for the full sample. Panel
B reports mean and standard deviation of each variable across live, liquidation, and other defunct fund-month
observations. Defunct funds mean funds dropped from the TASS database. Liquidation is one of seven drop reasons.
Other defunct funds mean that their drop reasons are not liquidation. In Panel B, even for a failed fund, non-failure
months are treated as live fund-month observations. A brief description of variables is as follows: Ret[t-m, t-k]
(geometric average of monthly net-of-fee returns over the period of month t-m to t-k), Investor Impatience[t-k]
(number of months, measured in month t-k, since a fund achieves its maximum value), Flow[t-m, t-k] (simple
average of monthly fund flows over [t-m, t-k]), Avg # of Missing AUM[t-m, t-k] (average number of months,
expressed in percents, that a fund’s assets under management (AUM) is missing over [t-m, t-k]), Size[t-k] (a fund’s
assets under management in month t-k), Volatility[t-k, t-m] (standard deviation of monthly returns over [t-k, t-m]),
Age[t] (number of months, measured in month t, since a fund enters the database), Redemption Notice Period (in
months), Lockup Period (in months), and Personal Capital (1 if principals have money invested, 0 otherwise). The
sample period is January 1994 to September 2007.
Panel B: Summary Statistics across Live, Liquidation, and Other Defunct Fund-Month Observations
Mean Std
Variable Alive Liquidation Other Defunct Alive Liquidation Other Defunct
Ret[t-6, t-1] (% per month) 0.71 -0.58 -0.13 2.26 3.42 3.06
Ret[t-12, t-7] 0.75 -0.11 0.29 2.30 2.26 2.66
Ret[t-24, t-13] 0.79 0.26 0.56 1.74 2.01 2.11
Investor Impatience[t-1] (months) 6.29 11.62 8.88 8.54 11.11 9.95
Investor Impatience[t-7] 5.60 8.91 7.28 7.87 9.74 8.98
Flow[t-6, t-1] (% per month) 1.10 -3.02 -0.77 7.53 8.14 7.17
Flow[t-12, t-7] 2.14 -0.98 0.43 9.22 7.97 7.60
Flow[t-24, t-13] 2.32 1.91 1.28 7.29 9.86 7.24
Avg # of Missing AUM[t-6, t-1] (%) 8.41 16.04 25.13 23.79 29.67 36.55
Avg # of Missing AUM[t-12, t-7] 7.91 12.46 16.62 23.31 28.16 32.26
Size[t-1] (millions) 173.53 42.26 117.83 459.64 123.47 430.35
Size[t-7] 157.33 54.45 111.37 405.26 141.42 358.57
Volatility[t-6, t-1] (% per month) 3.23 3.49 4.20 3.60 3.99 5.32
Volatility[t-12, t-7] 3.27 3.67 3.97 3.66 4.62 4.84
Age[t] (months) 39.52 37.96 42.54 26.09 21.26 25.76
Redemption Notice Period (months) 1.19 0.83 1.09 0.90 0.80 0.80
Lockup Period (months) 3.83 2.17 3.44 6.76 4.81 5.74
Personal Capital (0/1) 0.48 0.42 0.45 0.50 0.49 0.50
# of Observations 122,723 765 1,060 122,723 765 1,060
43
Table 2
Modeling the Failure Probability of Hedge Funds using a Dynamic Logit Regression (I)
This table reports results from the failure prediction model using a dynamic logit regression. If a fund fails in month
t, the fund’s failure indicator is 1 in month t and 0 in other months. In Panel A, failure means liquidation. In panel B,
failure means all defunct cases that stop reporting. Investor Impatience, Size, Age, and Lockup Period are included in
the logit regression after taking a log transformation. In each panel, Model 1 represents the main model, which
predicts a fund’s failure in month t using information measured in month t-1. Model 2 examines the nonlinear
effects of extremely negative returns and extreme fund outflows. Model 3 examines whether past performance and
fund flows measured in month t-13 provide additional failure predictability beyond the impacts of the covariates
measured in month t-1 on failure probability. A covariate’s positive (negative) parameter estimate implies that the
covariate increases (decreases) the failure probability. I report t-values using the standard errors clustered by fund.
The marginal effect of each variable represents the change in failure probability expressed in percents as a
continuous variable increases by one standard deviation at its mean value or a binary variable changes from zero to
one, ceteris paribus. December is a dummy variable which is one if an observation’s calendar month is December
and zero otherwise. Year denotes the calendar year of an observation. The effect of each style dummy variable is
relative to the effects of the other styles including the Long/Short Equity style. The pseudo-R2 of McFadden (1974)
for each regression model is computed as 1-L1/L0 where L1 is the log likelihood of the model and L0 is the log
likelihood of a null model with only a constant term. The sample period is January 1994 to September 2007.
44
Panel B: Defunct vs. Live Funds
Model 1 Model 2 Model 3
Expected Parameter t-value Marginal Parameter t-value Marginal Parameter t-value Marginal
Sign Estimate Effect Estimate Effect Estimate Effect
Ret[t-12, t-1] (-) -6.87 -4.89 -0.16% -11.25 -4.96 -0.26% -6.62 -4.13 -0.18%
I(Ret[t-12, t-1]<0) (+) 0.43 5.79 0.57% 0.35 4.40 0.47% 0.43 5.19 0.68%
Investor Impatience[t-1] (+) 0.09 3.16 0.13% 0.08 2.71 0.11% 0.06 2.09 0.12%
Flow[t-12, t-1] (-) -3.06 -4.67 -0.29% -2.25 -2.92 -0.21% -3.59 -4.61 -0.31%
I(Flow[t-12, t-1]<0) (+) 0.25 3.86 0.33% 0.27 4.09 0.36% 0.21 2.93 0.33%
Avg # of Missing AUM[t-12, t-1] (+) 1.38 18.90 0.41% 1.40 18.98 0.42% 1.39 17.08 0.50%
Size[t-1] (-) -0.25 -17.88 -0.62% -0.25 -17.71 -0.61% -0.23 -14.82 -0.67%
Volatility[t-12, t-1] (+) 0.27 0.33 0.01% 0.72 0.89 0.03% 1.43 1.65 0.08%
Ret[t-24, t-13] (-) -1.54 -0.85 -0.04%
I(Ret[t-24, t-13]<0) (+) 0.00 0.06 0.01%
Flow[t-24, t-13] (-) 0.71 1.59 0.08%
I(Flow[t-24, t-13]<0) (+) 0.23 3.49 0.36%
I(Ret[t-12, t-1]<0)*(Ret[t-12, t-1])^2 (+) -31.88 -2.02 -0.05%
I(Flow[t-12, t-1]<0)*(Flow[t-12, t-1])^2 (+) 12.49 2.02 0.04%
Age[t] (+) 5.01 14.04 4.82% 5.04 14.12 4.85% -0.45 -0.56 -0.35%
Age[t]^2 (-) -0.68 -12.82 -4.43% -0.69 -12.88 -4.45% 0.04 0.35 0.22%
Redemption Notice Period (-) -0.14 -3.95 -0.17% -0.15 -3.98 -0.17% -0.13 -3.49 -0.19%
Lockup Period (-) -0.06 -2.50 -0.09% -0.06 -2.39 -0.09% -0.05 -1.87 -0.09%
Personal Capital (-) -0.13 -2.48 -0.17% -0.13 -2.51 -0.17% -0.18 -3.18 -0.28%
December (+) 0.66 9.34 0.89% 0.66 9.39 0.89% 0.72 9.40 1.13%
Year 0.09 8.08 0.34% 0.09 8.14 0.34% 0.08 6.73 0.35%
Convertible Arbitrage 0.05 0.42 0.07% 0.05 0.44 0.07% 0.05 0.43 0.09%
Dedicated Short Bias -0.79 -3.07 -1.06% -0.81 -3.16 -1.09% -0.90 -3.13 -1.42%
Emerging Markets -0.22 -2.27 -0.30% -0.23 -2.32 -0.31% -0.28 -2.63 -0.44%
Equity Market Neutral 0.11 1.12 0.14% 0.11 1.10 0.14% 0.09 0.88 0.15%
Event Driven 0.15 1.78 0.20% 0.15 1.74 0.20% 0.14 1.55 0.23%
Fixed Income Arbitrage 0.39 3.47 0.52% 0.38 3.35 0.50% 0.35 2.82 0.55%
Global Macro 0.04 0.40 0.05% 0.05 0.46 0.06% 0.04 0.37 0.06%
Managed Futures -0.29 -3.23 -0.38% -0.28 -3.11 -0.37% -0.31 -3.14 -0.50%
Multi-Strategy -0.08 -0.65 -0.11% -0.08 -0.66 -0.11% -0.19 -1.31 -0.30%
McFadden's R-square 9.9% 9.9% 8.3%
# of Defunct Funds 1,825 1,825 1,543
# of Observations 134,461 134,461 95,816
45
Table 3
Modeling the Failure Probability of Hedge Funds using a Dynamic Logit Regression (II)
This table reports results from the failure prediction model using a dynamic logit regression. If a fund fails in month
t, the fund’s failure indicator is 1 in month t and 0 in other months. In Panel A, failure means liquidation. In panel B,
failure means all defunct cases that stop reporting. Investor Impatience, Size, Age, and Lockup Period are included in
the logit regression after taking a log transformation. In each panel, Model 1 represents the main model, which
predicts a fund’s failure in month t using information measured in month t-7 Model 2 examines whether past
performance and fund flows measured in month t-7 provide additional failure predictability beyond the impacts of
the covariates measured in month t-1 on failure probability. A covariate’s positive (negative) parameter estimate
implies that the covariate increases (decreases) the failure probability. I report t-values using the standard errors
clustered by fund. The marginal effect of each variable represents the change in failure probability expressed in
percents as a continuous variable increases by one standard deviation at its mean value or a binary variable changes
from zero to one, ceteris paribus. December is a dummy variable which is one if an observation’s calendar month is
December and zero otherwise. Year denotes the calendar year of an observation. The effect of each style dummy
variable is relative to the effects of the other styles including the Long/Short Equity style. The pseudo-R2 of
McFadden (1974) for each regression model is computed as 1-L1/L0 where L1 is the log likelihood of the model and
L0 is the log likelihood of a null model with only a constant term. The sample period is January 1994 to September
2007.
46
Panel B: Defunct vs. Live Funds
Model 1 Model 2
Expected Parameter t-value Marginal Parameter t-value Marginal
Sign Estimate Effect Estimate Effect
Ret[t-6, t-1] (-) -5.32 -4.64 -0.18%
I(Ret[t-6, t-1]<0) (+) 0.39 5.72 0.56%
Investor Impatience[t-1] (+) 0.09 3.18 0.15%
Flow[t-6, t-1] (-) -2.35 -4.01 -0.26%
I(Flow[t-6, t-1]<0) (+) 0.29 4.42 0.42%
Avg # of Missing AUM[t-6, t-1] (+) 1.58 21.67 0.55%
Size[t-1] (-) -0.25 -17.64 -0.66%
Volatility[t-6, t-1] (+) 0.16 0.20 0.01%
Ret[t-12, t-7] (-) -4.23 -3.82 -0.14% -2.12 -1.90 -0.07%
I(Ret[t-12, t-7]<0) (+) 0.17 2.53 0.25% 0.04 0.67 0.06%
Investor Impatience[t-7] (+) 0.08 2.95 0.12%
Flow[t-12, t-7] (-) -1.57 -3.43 -0.21% -0.88 -2.14 -0.12%
I(Flow[t-12, t-7]<0) (+) 0.19 3.11 0.27% 0.15 2.49 0.22%
Avg # of Missing AUM[t-12, t-7] (+) 1.05 12.97 0.36%
Size[t-7] (-) -0.22 -16.17 -0.58%
Volatility[t-12, t-7] (+) 1.08 1.69 0.06%
Age[t] (+) 3.71 8.82 3.46% 3.43 8.19 3.19%
Age[t]^2 (-) -0.51 -8.33 -3.31% -0.47 -7.80 -3.08%
Redemption Notice Period (-) -0.18 -4.98 -0.24% -0.14 -3.92 -0.19%
Lockup Period (-) -0.06 -2.79 -0.11% -0.05 -2.35 -0.09%
Personal Capital (-) -0.16 -3.22 -0.24% -0.13 -2.55 -0.19%
December (+) 0.64 9.08 0.93% 0.64 8.97 0.92%
Year 0.06 5.98 0.26% 0.09 8.45 0.38%
Convertible Arbitrage 0.04 0.36 0.06% 0.06 0.47 0.08%
Dedicated Short Bias -0.62 -2.45 -0.90% -0.75 -2.90 -1.08%
Emerging Markets -0.26 -2.65 -0.37% -0.21 -2.11 -0.30%
Equity Market Neutral 0.10 1.02 0.14% 0.12 1.28 0.18%
Event Driven 0.10 1.18 0.14% 0.16 1.81 0.22%
Fixed Income Arbitrage 0.33 2.96 0.47% 0.40 3.55 0.58%
Global Macro 0.12 1.25 0.18% 0.02 0.22 0.03%
Managed Futures -0.23 -2.65 -0.34% -0.27 -3.06 -0.40%
Multi-Strategy -0.15 -1.18 -0.22% -0.08 -0.62 -0.11%
McFadden's R-square 5.7% 9.7%
# of Defunct Funds 1,824 1,825
# of Observations 123,909 124,548
47
Table 4
Out-of-Sample Predictability of the Failure Prediction Model
This table examines the out-of-sample predictability of the failure prediction models (Model 1 in Table 2 and Model
1 in Table 3). At the beginning of each month, I run the failure prediction models (excluding Year variable) using
either 1-month (Panel A) or 7-month (Panel B) lagged covariates and estimate the predicted failure probability of
hedge funds. I sort all funds into quintiles by the predicted failure probability and examine the number of failed
funds in each quintile. In each panel, I consider two definitions of failure: liquidation only and all defunct cases.
Quintiles are formed from January 1996 (in Panel A) or July 1996 (in Panel B) to September 2007.
Panel A: Number of Failed Funds per Year across Quintiles (where failures are predicted by 1-month lagged covariates)
# of Funds per Panel A-1: Failure = Liquidation Panel A-2: Failure = Defunct
month in each # of # of
Year quintile Low quin2 quin3 quin4 High Liquidation Low quin2 quin3 quin4 High Defunct
1996 34 2 2 1 2 5 12 2 3 1 5 14 25
1997 65 0 0 1 1 15 17 0 0 0 4 23 27
1998 93 4 0 2 13 44 63 4 0 4 24 61 93
1999 116 0 0 3 4 51 58 2 1 8 11 81 103
2000 121 2 1 7 16 32 58 3 8 20 34 80 145
2001 138 1 1 2 10 27 41 4 4 10 24 74 116
2002 212 3 0 6 14 38 61 0 7 21 33 67 128
2003 252 1 2 12 20 52 87 3 14 16 40 79 152
2004 284 2 4 14 25 52 97 2 11 25 50 91 179
2005 318 4 7 11 31 67 120 11 13 31 63 148 266
2006 346 3 1 9 17 73 103 13 23 46 60 177 319
2007 340 3 4 5 8 20 40 22 36 37 59 110 264
Total 25 22 73 161 476 757 66 120 219 407 1,005 1,817
Panel B: Number of Failed Funds per Year across Quintiles (where failures are predicted by 7-month lagged covariates)
# of Funds per Panel B-1: Failure = Liquidation Panel B-2: Failure = Defunct
month in each # of # of
Year quintile Low quin2 quin3 quin4 High Liquidation Low quin2 quin3 quin4 High Defunct
1996 33 2 1 1 2 2 8 3 1 1 4 7 16
1997 56 0 0 2 2 13 17 0 1 2 3 21 27
1998 83 4 0 1 17 40 62 4 2 4 18 64 92
1999 105 0 0 5 4 49 58 1 5 8 13 76 103
2000 116 2 4 9 14 29 58 5 10 24 33 73 145
2001 120 1 3 5 18 14 41 8 10 14 31 53 116
2002 188 3 5 9 20 24 61 4 15 23 31 55 128
2003 237 3 4 12 22 46 87 10 22 23 42 55 152
2004 268 5 8 19 23 42 97 7 22 28 51 71 179
2005 297 8 11 17 39 45 120 15 30 44 61 116 266
2006 327 5 6 20 20 52 103 18 28 67 71 135 319
2007 322 2 7 4 7 20 40 36 40 36 48 104 264
Total 35 49 104 188 376 752 111 186 274 406 830 1,807
48
Table 5
Average Characteristics of Quintiles based on the Predicted Failure Probability
This table reports the average characteristics of each quintile based on the predicted failure probability. Fund-month
observations are used to compute the average characteristics. At the beginning of each month, I run the failure
prediction models using either 1-month (Panel A) or 7-month (Panel B) lagged covariates and estimate the predicted
failure probability of hedge funds. I sort all funds into quintiles by the failure probability. In each panel, I consider
two definitions of failure: liquidation only and all defunct cases. Quintiles are formed from January 1996 (in Panel
A) or July 1996 (in Panel B) to September 2007.
Panel A: Average Characteristics across Quintiles (where failures are predicted by 1-month lagged covariates)
Panel A-1: Failure = Liquidation Panel A-2: Failure = Defunct
Variables Low quin2 quin3 quin4 High Low quin2 quin3 quin4 High
Ret[t-12, t-1] (% per month) 1.42 1.10 0.79 0.44 -0.21 1.34 1.09 0.85 0.49 -0.23
Investor Impatience[t-1] (months) 2.84 3.64 5.03 7.07 11.84 2.71 3.58 4.84 7.22 12.08
Flow[t-12, t-1] (% per month) 7.00 3.30 1.51 -0.12 -2.25 6.72 3.12 1.59 -0.06 -1.92
Avg # of Missing AUM[t-12, t-1] (%) 5.24 6.16 7.50 9.08 12.68 3.72 4.50 5.93 8.28 18.25
Size[t-1] (millions) 421.83 201.46 112.20 65.34 29.21 407.84 208.49 115.05 66.78 31.82
Volatility[t-12, t-1](% per month) 3.44 3.38 3.33 3.49 3.56 3.10 3.16 3.31 3.55 4.08
Age[t] (months) 35.15 36.19 38.42 38.56 38.30 33.19 36.96 38.27 39.07 39.10
Redemption Notice Period (months) 1.60 1.35 1.17 1.00 0.82 1.60 1.33 1.17 1.01 0.84
Lockup Period (months) 6.42 4.22 3.54 3.00 2.02 6.14 4.11 3.50 3.08 2.37
Personal Capital (0/1) 0.54 0.50 0.48 0.44 0.39 0.52 0.50 0.48 0.45 0.42
Failure Probability (% per month) 0.04 0.10 0.20 0.42 1.92 0.14 0.32 0.57 1.08 3.43
Panel B: Average Characteristics across Quintiles (where failures are predicted by 7-month lagged covariates)
Panel B-1: Failure = Liquidation Panel B-2: Failure = Defunct
Variables Low quin2 quin3 quin4 High Low quin2 quin3 quin4 High
Ret[t-12, t-7] (% per month) 1.52 1.18 0.79 0.45 -0.24 1.43 1.16 0.86 0.50 -0.24
Investor Impatience[t-7] (months) 2.56 3.54 5.00 6.88 10.31 2.52 3.49 4.91 6.95 10.41
Flow[t-12, t-7] (% per month) 6.74 3.42 1.94 0.33 -1.87 6.31 3.54 2.05 0.30 -1.65
Avg # of Missing AUM[t-12, t-7] (%) 5.69 6.33 6.86 8.00 10.58 3.63 4.53 5.72 7.10 16.47
Size[t-7] (millions) 397.74 186.83 103.53 63.33 30.66 410.91 179.50 101.47 61.15 29.07
Volatility[t-12, t-7](% per month) 3.10 3.19 3.19 3.41 3.48 2.78 2.98 3.16 3.47 3.99
Age[t] (months) 43.35 39.06 38.64 38.63 38.67 41.79 38.58 38.78 39.57 39.62
Redemption Notice Period (months) 1.70 1.38 1.16 0.96 0.77 1.70 1.35 1.15 0.97 0.80
Lockup Period (months) 6.71 4.52 3.59 2.76 1.68 6.36 4.18 3.56 2.93 2.21
Personal Capital (0/1) 0.59 0.52 0.47 0.43 0.37 0.57 0.50 0.47 0.44 0.40
Failure Probability (% per month) 0.08 0.18 0.31 0.56 1.78 0.27 0.52 0.82 1.34 3.18
49
Table 6
Time-Series Regressions for Quintile Portfolios based on the Predicted Failure Probability
This table reports the results of monthly time-series regressions for quintile portfolios and zero-cost spread portfolio
based on the predicted failure probability. At the beginning of each month, I run the failure prediction models using
7-month lagged covariates (where failure means liquidation in Panel A and all defunct cases in Panel B) or 1-month
lagged covariates (where failure means liquidation in Panel C and all defunct cases in Panel D). Subsequently, I
estimate the predicted failure probability of hedge funds, sort all funds into quintiles by the failure probability, and
examine equally-weighted portfolio returns during the month. In each panel, Low (High) denotes the lowest
(highest) failure risk quintile. I report both the average raw return (Raw Ret) and alpha of each portfolio in
percentage. To measure alpha, I run a monthly time-series regression that includes following risk factors: Fung and
Hsieh’s seven factors, book-to-market factor (HML), Carhart’s momentum factor (UMD), and two (1-month and 2-
month) lagged excess market returns. The Fung-Hsieh seven factors include excess market returns (MKTRF), size
factor (SMB), change in credit spreads (Moody's Baa yield minus 10-year treasury yield (∆DEF)), change in 10-year
treasury yields (∆Y10), and three primitive trend-following factors on bond (PTFBD), currency (PTFFX), and
commodity (PTFCOM). Credit spreads and 10-year treasury yields are multiplied by 100. For parameters in the
regression, first row reports coefficient estimates, and second row reports corresponding t-statistics in parentheses.
Adjusted R2 of each regression is also reported. Monthly time-series regressions are based on the period July 1996
(in Panel A and B) or January 1996 (in Panel C and D) to September 2007.
Panel A: Failure = Liquidation (where failures are predicted by 7-month lagged covariates)
Failure Raw MKT- PTF-
Alpha LAG1 LAG2 SMB HML UMD ∆DEF ∆Y10 PTF-BD PTF-FX Adj-R2
Risk Return RF COM
Low 0.83 0.27 0.21 0.03 0.03 0.13 0.04 0.03 -0.01 0.00 -0.01 0.01 0.01 0.57
(6.17) (2.85) (8.35) (1.10) (1.61) (4.78) (1.23) (1.82) (-1.21) (-0.47) (-1.45) (1.02) (1.01)
Quin2 0.88 0.28 0.33 0.06 0.02 0.14 -0.08 0.07 -0.03 -0.01 -0.01 0.01 0.01 0.75
(4.44) (2.59) (11.19) (2.24) (0.85) (4.52) (-1.99) (3.19) (-2.39) (-1.09) (-1.08) (1.52) (1.11)
Quin3 0.77 0.18 0.35 0.03 0.03 0.15 0.01 0.02 -0.03 -0.01 0.01 0.01 0.00 0.72
(4.04) (1.67) (12.06) (1.16) (1.02) (4.89) (0.16) (0.98) (-2.32) (-1.19) (0.82) (1.43) (0.51)
Quin4 0.56 -0.01 0.36 0.03 -0.01 0.15 0.02 0.02 -0.02 -0.01 0.01 0.01 0.01 0.71
(2.97) (-0.12) (12.16) (1.02) (-0.26) (4.59) (0.47) (0.72) (-1.80) (-1.05) (1.32) (1.93) (1.41)
High 0.30 -0.34 0.35 0.03 0.00 0.18 0.12 0.01 -0.03 -0.01 0.00 0.01 0.00 0.66
(1.60) (-2.94) (11.27) (0.95) (-0.02) (5.37) (2.86) (0.49) (-2.52) (-1.54) (-0.60) (0.78) (0.50)
L-H 0.53 0.61 -0.14 0.00 0.04 -0.05 -0.08 0.02 0.02 0.01 0.00 0.00 0.00 0.18
(4.28) (5.10) (-4.30) (-0.05) (1.30) (-1.41) (-1.79) (0.96) (1.48) (1.11) (-0.56) (0.05) (0.32)
Panel B: Failure = Defunct (where failures are predicted by 7-month lagged covariates)
Failure Raw MKT- PTF-
Alpha LAG1 LAG2 SMB HML UMD ∆DEF ∆Y10 PTF-BD PTF-FX Adj-R2
Risk Return RF COM
Low 0.88 0.36 0.21 0.03 0.02 0.12 0.01 0.03 -0.02 -0.01 -0.01 0.01 0.01 0.58
(6.39) (3.68) (8.08) (1.34) (0.90) (4.22) (0.30) (1.61) (-1.98) (-0.92) (-1.12) (0.95) (1.18)
Quin2 0.88 0.24 0.33 0.05 0.03 0.13 -0.02 0.08 -0.01 0.00 -0.01 0.01 0.00 0.71
(4.79) (2.30) (11.57) (1.91) (1.07) (4.31) (-0.51) (3.87) (-1.06) (-0.30) (-0.87) (1.43) (0.62)
Quin3 0.75 0.17 0.35 0.04 0.03 0.14 -0.03 0.03 -0.03 -0.01 0.01 0.01 0.00 0.72
(3.92) (1.59) (11.69) (1.33) (1.31) (4.36) (-0.73) (1.34) (-2.39) (-1.52) (1.06) (1.69) (0.53)
Quin4 0.54 -0.05 0.37 0.03 0.00 0.16 0.03 0.01 -0.02 -0.01 0.01 0.01 0.01 0.75
(2.90) (-0.45) (13.50) (1.37) (0.10) (5.54) (0.75) (0.73) (-2.07) (-1.13) (1.18) (1.24) (1.30)
High 0.28 -0.35 0.35 0.02 -0.01 0.20 0.12 -0.01 -0.04 -0.01 -0.01 0.01 0.01 0.70
(1.47) (-3.10) (11.57) (0.67) (-0.26) (6.19) (2.96) (-0.25) (-3.03) (-1.65) (-1.08) (1.48) (1.05)
L-H 0.60 0.71 -0.14 0.01 0.03 -0.08 -0.11 0.04 0.02 0.01 0.00 0.00 0.00 0.22
(4.95) (6.15) (-4.63) (0.46) (1.01) (-2.57) (-2.67) (1.60) (1.33) (0.86) (0.13) (-0.66) (-0.05)
50
Panel C: Failure = Liquidation (where failures are predicted by 1-month lagged covariates)
Failure Raw MKT- PTF-
Alpha LAG1 LAG2 SMB HML UMD ∆DEF ∆Y10 PTF-BD PTF-FX Adj-R2
Risk Return RF COM
Low 0.96 0.35 0.24 0.03 0.04 0.12 0.03 0.06 -0.02 -0.01 -0.01 0.01 0.01 0.57
(6.62) (3.42) (8.41) (1.17) (1.80) (4.07) (0.80) (2.95) (-1.68) (-1.01) (-1.57) (1.94) (0.81)
Quin2 0.94 0.26 0.35 0.03 0.03 0.18 -0.03 0.11 -0.03 -0.01 -0.01 0.01 0.01 0.75
(4.67) (2.35) (11.72) (0.99) (1.27) (5.72) (-0.89) (4.94) (-2.10) (-1.17) (-0.79) (1.81) (1.66)
Quin3 0.77 0.14 0.33 0.05 0.03 0.14 -0.02 0.05 -0.03 -0.01 0.00 0.01 0.01 0.69
(4.17) (1.27) (10.71) (1.88) (1.04) (4.34) (-0.57) (2.31) (-2.32) (-1.24) (-0.30) (1.79) (1.15)
Quin4 0.63 0.11 0.33 0.01 0.00 0.13 0.00 -0.02 -0.03 -0.01 0.01 0.01 0.02 0.67
(3.54) (1.02) (10.77) (0.37) (-0.18) (4.14) (0.10) (-1.02) (-2.79) (-1.77) (1.10) (1.57) (1.97)
High 0.27 -0.30 0.32 0.04 -0.02 0.15 0.06 -0.06 -0.02 0.00 -0.02 0.01 0.01 0.68
(1.54) (-2.79) (11.08) (1.35) (-0.68) (4.98) (1.59) (-2.59) (-1.86) (-0.62) (-2.00) (1.11) (1.61)
L-H 0.69 0.65 -0.09 -0.01 0.06 -0.03 -0.03 0.12 0.00 0.00 0.00 0.00 -0.01 0.30
(5.44) (5.62) (-2.73) (-0.20) (2.23) (-0.97) (-0.75) (5.02) (0.22) (-0.33) (0.44) (0.70) (-0.77)
Panel D: Failure = Defunct (where failures are predicted by 1-month lagged covariates)
Failure Raw MKT- PTF-
Alpha LAG1 LAG2 SMB HML UMD ∆DEF ∆Y10 PTF-BD PTF-FX Adj-R2
Risk Return RF COM
Low 0.96 0.36 0.23 0.03 0.04 0.13 0.02 0.07 -0.02 0.00 -0.01 0.01 0.00 0.59
(6.56) (3.58) (8.35) (1.39) (1.73) (4.46) (0.48) (3.29) (-1.86) (-0.85) (-1.21) (1.79) (0.58)
Quin2 0.90 0.21 0.34 0.03 0.03 0.17 -0.01 0.10 -0.02 -0.01 -0.02 0.01 0.01 0.72
(4.70) (1.90) (11.18) (1.00) (1.21) (5.46) (-0.13) (4.34) (-1.63) (-0.84) (-1.92) (1.68) (1.05)
Quin3 0.84 0.22 0.35 0.06 0.02 0.11 -0.02 0.05 -0.03 -0.01 0.00 0.01 0.01 0.68
(4.65) (2.00) (11.36) (2.07) (0.73) (3.32) (-0.47) (2.36) (-2.09) (-1.52) (0.46) (1.62) (1.57)
Quin4 0.58 0.04 0.31 0.01 0.02 0.14 -0.01 0.01 -0.04 -0.01 0.01 0.01 0.02 0.70
(3.42) (0.41) (11.05) (0.52) (0.86) (4.67) (-0.15) (0.56) (-3.59) (-2.05) (1.62) (1.35) (2.13)
High 0.28 -0.27 0.34 0.02 -0.03 0.18 0.05 -0.08 -0.02 0.00 -0.02 0.01 0.02 0.71
(1.45) (-2.42) (11.22) (0.81) (-1.18) (5.56) (1.20) (-3.78) (-1.84) (-0.68) (-2.29) (1.86) (1.94)
L-H 0.68 0.63 -0.11 0.01 0.07 -0.05 -0.03 0.15 0.00 0.00 0.01 0.00 -0.01 0.42
(5.01) (5.61) (-3.62) (0.44) (2.72) (-1.50) (-0.76) (6.70) (0.15) (-0.08) (1.18) (-0.23) (-1.40)
51
Table 7
Robustness Checks (I): Sub-Sample Analysis
This table reports several sub-sample analysis results of monthly time-series regressions for quintile portfolios and
zero-cost spread portfolio based on the predicted failure probability. The procedures of the analysis are the same as
those described in Table 6. In each panel, I consider two sub-samples that (1) remove failure month returns and (2)
remove the bottom quintile (based on fund size) of the full sample in each month. For each regression, I report only
alpha estimate in percentage and its corresponding t-statistic in parenthesis. Monthly time-series regressions are
based on the period July 1996 (in Panel A) or January 1996 (in Panel B) to September 2007.
52
Table 8
Robustness Checks (II): Time-varying vs. Constant Covariate Effects
This table examines how time-varying covariates and constant covariates affect the return spread based on failure
risk. In Panel A, failures are predicted by both time-varying and constant covariates. In Panel B, failures are
predicted by only time-varying covariates. In Panel C, failures are predicted by only constant covariates. In each
panel, I consider both definitions of failures and report the alphas of monthly time-series regressions (in Table 6) for
quintile portfolios and zero-cost spread portfolio based on the predicted failure probability. In each specification,
failures are predicted by either 7-month lagged information (Model 1 in Table 3) or 1-month lagged information
(Model 1 in Table 2). I report alpha estimates in percentage and their corresponding t-statistics in parenthesis.
Monthly time-series regressions are based on the period July 1996 (when failures are predicted by 7-month lagged
covariates) or January 1996 (1-month lagged covariates) to September 2007.
53
Table 9
Interaction Effect of Failure Risk and Share Restrictions on Hedge Fund Returns
This table reports the interaction effect of failure risk and share restrictions on future fund returns. Following the
procedure described in Table 6, I estimate monthly failure probability for each hedge fund. At the beginning of each
month, I sort all funds into two groups based on a share restriction (either a redemption notice period or a lockup
period), then sort the funds in each group into tertiles by their predicted failure probability. When a redemption
notice period is used, I use the median of redemption notice periods as a cutoff value in each month (Short denotes
below median, Long denotes above median). When a lockup period is used, I follow Aragon (2007) and group all
funds into two groups based on whether a fund imposes a lockup provision or not (Yes if a fund uses a lockup
provision, No otherwise). For each of two share restrictions, I form six equally-weighted portfolios every month and
examine their average monthly returns after adjusting for the nine risk factors and a return smoothing effect defined
in Table 6. For simplicity, I report the case where failures are predicted by 7-month lagged information. In Panel A,
failure means liquidation. In Panel B, failure means all defunct cases. For each time-series regression, I report only
alpha estimate in percentage and its corresponding t-statistic in parenthesis. Monthly time-series regressions are
based on the period of July 1996 to September 2007.
54
Table 10
Failure Risk Effect after controlling for Covariate Effects: Cross-Sectional Regressions (I)
This table reports Fama-MacBeth’s cross-sectional regression results. Panel A reports the univariate cross-sectional
regression results based on equation (8). Panel B reports the multivariate cross-sectional regression results based on
equation (9). In each month, I run a cross-sectional regression across funds. Subsequently, I report the time-series
average of monthly parameter estimates for each independent variable and its Newey-West t-statistic (with a lag of
2) in parenthesis. The time-series average of monthly adjusted R-squares is also reported for each model. For each
cross-sectional regression, the dependent variable is the monthly excess returns of hedge funds over 1-month T-bill
rate. I multiply the excess return by 100 to make it a percentage number. Failure Risk is a rank variable of the
predicted failure probability, ranging from 1 to 10. Investor Impatience, Size, and Age are included in a cross-
sectional regression after taking a log transformation. Sample period is July 1996 (for 7-month lagged covariates) or
January 1996 (for 1-month lagged covariates) to September 2007. * indicates statistical significance at the 10%
level, ** at the 5% level, and *** at the 1% level.
55
Table 11
Failure Risk Effect after controlling for Covariate Effects: Cross-Sectional Regressions (II)
This table examines how a fund’s failure risk affects its future returns even after excluding one of important
covariates (performance predictors) when predicting fund failures and estimating failure probability. I consider five
covariates (past performance, investor impatience, redemption notice period, lockup period, and managerial
ownership) that significantly predict future fund returns (Panel A in Table 9). Failures are predicted by the other
covariates excluding a specific covariate. By doing so, the predicted failure probability measure does not include the
specific covariate component. Subsequently, I run a cross-sectional regression including only two variables: failure
risk (without a covariate component) and the covariate. In Panel A (Panel B), failures are predicted by 7-month (1-
month) lagged information. In each panel, both definitions of failures are considered. I follow the Fama-MacBeth’s
cross-sectional regression approach (see the description in Table 9). Estimate reports the time-series average of
monthly parameter estimates for each independent variable (either failure risk or a covariate). t-value reports
Newey-West t-statistic (with a lag of 2) in parenthesis. For each cross-sectional regression, the dependent variable is
the monthly excess returns of hedge funds over 1-month T-bill rate. I multiply the excess return by 100. Failure Risk
is a rank variable of the predicted failure probability, ranging from 1 to 10. Impatience is a log-transformed variable.
Lockup is a dummy variable that takes 1 if a fund uses a lockup provision. Sample period is July 1996 (for 7-month
lagged covariates) or January 1996 (for 1-month lagged covariates) to September 2007. * indicates statistical
significance at the 10% level, ** at the 5% level, and *** at the 1% level.
56
Panel A: Liquidation Funds
4
Returns/Flows (% per month)
0
23 22 21 20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0
-2
-4
-6
-8
Time-to-Liquidation (months)
4
Returns/Flows (% per month)
0
23 22 21 20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0
-2
-4
-6
Time-to-Defunct (months)
Figure 1. Equally-weighted returns and fund flows of failed funds. This figure provides the (event) time-
series plots of equally-weighted returns and fund flows of failed funds over the last 24 months until they fail. In
Panel A, failure means liquidation. In Panel B, failure implies all defunct cases. In each panel, I construct two sub-
samples of failed funds: (1) funds that do not require any lockup and redemption notice period and (2) funds that fail
in a month that is not their fiscal year-end month. The dotted lines indicate plots based on two sub-samples.
57
Figure 2. Distribution of returns and fund flows of liquidation funds. This figure gives the distribution of
returns (Panel A) and fund flows (Panel B) of liquidation funds in a sequential way. In each panel, I also display a
fitted normal curve on the histogram.
58
Figure 3. Monthly time-series returns of two extreme quintile portfolios grouped by the predicted
failure probability. This figure gives the monthly time-series returns of two quintile portfolios grouped by failure
probability where failure means liquidation and failures are predicted by either 7-month (Panel A) or 1-month (Panel
B) lagged covariates. In each panel, High (Low) denotes the highest (lowest) failure risk quintile portfolio.
59