Failure Risk and the Cross-Section of Hedge Fund Returns

Jung-Min Kim†‡

Department of Finance
Fisher College of Business
The Ohio State University

This version: August 2008

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

predict the fund’s future returns.

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

its manager and it is closed.

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

predicted by 1-month as well as by 7-month lagged information. In addition, I examine the

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

failure prediction model are not sensitive to how failure is defined.

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

July 1996 to September 2007.

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

spread is still 6.93~7.44% per year.

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

effects of performance persistence, investor impatience, flow-performance relation, frequency of

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

subsumed by the findings of the prior literature.

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

the Fama-MacBeth approach at the fund level. Section 6 concludes.

2. Data

2.1. Sample Selection

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

be available to the public, I exclude them.7

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

detailed information about each of defunct funds is not available.

2.2. How does a typical Hedge Fund Fail?

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

impatience measure to be 1 month. In month t-23, investor impatience becomes 2 months. In

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:

AUM t - AUM t -1 (1+ Rett )

Flowt = , where AUM = Assets Under Management . (2)
AUM t-1

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

percentiles 10 . Similar to the performance measure, I compute a simple moving average of

monthly fund flows over the prior 6 or 12 months in month t as follows:

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

report AUM over the prior 6 or 12 months:

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

that higher missing rates increase failure probability.

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

under management (AUM).

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

volatility of a fund in each month.

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

measured by the number of months since a fund enters the database.

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

and Wermers (2008)).

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.

2.4. Summary Statistics

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

fund manager invests her own capital in the fund.

In Panel B, we find that the average return of failure-month observations is substantially

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

lower presence of managerial ownership.

3. Modeling the Failure Probability of Hedge Funds

3.1. Model Specification

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

the dynamic logit model.

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

hazard rate model.

Since I model the failure probability of hedge funds using a dynamic logit regression, the

failure probability is mathematically specified as follows:

⎛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-

month lagged) information as well as by older (7-month or 13-month lagged) information.

19
 In addition to the variables described in table 1, I consider I(Ret[t-m, t-k]<0) (1 if Ret[t-

m, t-k] is negative, 0 otherwise) and I(Flow[t-m, t-k]<0) (1 if Flow[t-m, t-k] is negative, 0

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

including the Long/Short Equity style.

3.2. Regression Results

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

sensitive to how failure is defined.

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

binary variable moves from zero to one, ceteris paribus.

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

flow information does not provide significantly additional failure predictability.

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

model is not sensitive to how failure is defined.

4. Failure Probability and the Cross-Section of Hedge Fund Returns

4.1. Hedge Fund Portfolios grouped by Predicted Failure Probability

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

prediction analysis, and (3) it allows me to implement a trading strategy.

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

predicted failure probability.

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

predictability when failure means all defunct cases.

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

of managerial ownership. In particular, when failures are predicted by 7-month lagged

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

based on 7-month lagged information is 1.78% per month.

4.2. Performance of Hedge Fund Portfolios grouped by Predicted Failure Probability

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

(when failures are predicted by 7-month lagged covariates) to September 2007.

To do a time-series performance test, we need an asset pricing model to adjust for

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

look-back straddle) factors on bonds (PTFBD), currencies (PTFFX), and commodities

(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

following time-series regression for each quintile portfolio:

ri , t = α i + β1(0) i MKTRFt + β1(1) i MKTRFt −1 + β1(2) i MKTRFt − 2 + β 2 i SMBt + β 3i HMLt + β 4 iUMDt

, (7)
+ β5 i (∆DEF )t + β 6 i (∆Y 10)t + β 7 i PTFBDt + β8 i PTFFX t + β 9 i PTFCOM t + ε i , t

where ri , t is the excess returns of quintile portfolio i in month t, and α i measures the average

risk-adjusted excess return of quintile portfolio i.

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.

4.3. Robustness Checks

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

slightly smaller than the original results in Table 6.

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-

month lagged information (Model 1 in Table 3) or 1-month lagged information (Model 1 in

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

more likely to perform poorly when their failure risk is high.

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

performance when their failure risk is high.

5. Is the Failure Risk Effect Subsumed by Covariate Effects?

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

regression approach of Fama and MacBeth (1973) at the fund level.21

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

2007, I run the following univariate cross-sectional regressions across funds:

ri, t = at + b j, t Covariate j [t - k]i + ei, t , (8)

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

Newey and West (1987) adjusted t-statistic in parenthesis.

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

with superior performance.

5.2. Is the Failure Risk Effect Subsumed by Covariate Effects?

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

its Newey-West adjusted t-statistic in parenthesis.

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

ownership on future performance is reduced after the failure risk is controlled.

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

funds in each month as follows:

ri, t = at + b1, t FailureRisk(-j) [t - k]i + b j, t Covariate j [t - k]i + ei, t , (10)

where ri , t is the excess return of fund i in month t, k = 7 or 1, m = 12, FailureRisk(-j) is a rank

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

Newey-West adjusted t-statistic in parenthesis. Overall (based on 20 different specifications: 2

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

that the failure risk effect is a robust finding.

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

are associated with higher failure risk.

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 A: Summary Statistics in Full Sample

Variable Mean Std Min Max
Ret[t-6, t-1] (% per month) 0.69 2.28 -58.89 35.03
Ret[t-12, t-7] 0.74 2.31 -39.15 57.79
Ret[t-24, t-13] 0.79 1.74 -26.35 27.11
Investor Impatience[t-1] (months) 6.34 8.59 1.00 83.00
Investor Impatience[t-7] 5.63 7.90 1.00 83.00
Flow[t-6, t-1] (% per month) 1.06 7.54 -40.60 103.22
Flow[t-12, t-7] 2.10 9.20 -40.60 201.34
Flow[t-24, t-13] 2.30 7.31 -27.79 107.93
Avg # of Missing AUM[t-6, t-1] (%) 8.60 24.02 0.00 100.00
Avg # of Missing AUM[t-12, t-7] 8.01 23.44 0.00 100.00
Size[t-1] (millions) 172.25 458.22 0.00 10,679.31
Size[t-7] 156.30 403.88 0.00 9,265.99
Volatility[t-6, t-1] (% per month) 3.24 3.62 0.00 120.20
Volatility[t-12, t-7] 3.28 3.68 0.00 160.61
Age[t] (months) 39.54 26.07 10.00 189.00
Redemption Notice Period (months) 1.19 0.90 0.00 6.00
Lockup Period (months) 3.81 6.74 0.00 90.00
Personal Capital (0/1) 0.48 0.50 0.00 1.00
# of Funds 3,421
# of Observations 124,548

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.

Panel A: Liquidation vs. Non-liquidation 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] (-) -11.90 -5.43 -0.12% -13.60 -4.17 -0.13% -12.29 -5.21 -0.14%
I(Ret[t-12, t-1]<0) (+) 0.46 4.08 0.26% 0.43 3.59 0.24% 0.43 3.49 0.29%
Investor Impatience[t-1] (+) 0.14 3.22 0.09% 0.14 3.09 0.09% 0.10 2.03 0.08%
Flow[t-12, t-1] (-) -5.29 -4.96 -0.21% -4.31 -2.63 -0.17% -5.64 -4.69 -0.21%
I(Flow[t-12, t-1]<0) (+) 0.35 3.43 0.20% 0.38 3.41 0.22% 0.35 3.06 0.23%
Avg # of Missing AUM[t-12, t-1] (+) 0.86 6.94 0.11% 0.88 6.99 0.11% 0.83 6.01 0.13%
Size[t-1] (-) -0.30 -14.54 -0.31% -0.30 -14.58 -0.31% -0.30 -13.06 -0.37%
Volatility[t-12, t-1] (+) -8.01 -4.79 -0.16% -7.78 -4.57 -0.16% -7.41 -4.08 -0.17%
Ret[t-24, t-13] (-) -2.11 -0.70 -0.02%
I(Ret[t-24, t-13]<0) (+) 0.07 0.55 0.04%
Flow[t-24, t-13] (-) 1.59 2.66 0.08%
I(Flow[t-24, t-13]<0) (+) 0.28 2.85 0.19%
I(Ret[t-12, t-1]<0)*(Ret[t-12, t-1])^2 (+) -9.92 -0.60 -0.01%
I(Flow[t-12, t-1]<0)*(Flow[t-12, t-1])^2 (+) 9.76 0.98 0.01%
Age[t] (+) 5.92 10.52 2.41% 5.93 10.55 2.41% 0.07 0.06 0.02%
Age[t]^2 (-) -0.83 -9.75 -2.26% -0.83 -9.77 -2.27% -0.04 -0.27 -0.11%
Redemption Notice Period (-) -0.26 -3.99 -0.13% -0.26 -4.00 -0.13% -0.23 -3.38 -0.14%
Lockup Period (-) -0.10 -2.62 -0.07% -0.10 -2.57 -0.07% -0.09 -2.19 -0.07%
Personal Capital (-) -0.24 -3.12 -0.14% -0.24 -3.14 -0.14% -0.29 -3.38 -0.19%
December (+) 0.85 8.47 0.48% 0.85 8.48 0.48% 0.87 8.04 0.58%
Year -0.01 -0.86 -0.02% -0.01 -0.84 -0.02% -0.02 -1.19 -0.04%
Convertible Arbitrage 0.16 0.88 0.09% 0.16 0.90 0.09% 0.02 0.10 0.01%
Dedicated Short Bias -0.63 -1.69 -0.35% -0.65 -1.74 -0.37% -0.69 -1.72 -0.46%
Emerging Markets -0.13 -0.85 -0.07% -0.14 -0.91 -0.08% -0.21 -1.29 -0.14%
Equity Market Neutral 0.35 2.59 0.20% 0.35 2.61 0.20% 0.29 1.96 0.19%
Event Driven 0.10 0.70 0.06% 0.10 0.70 0.06% 0.09 0.62 0.06%
Fixed Income Arbitrage 0.13 0.68 0.07% 0.12 0.65 0.07% 0.07 0.34 0.05%
Global Macro -0.14 -0.86 -0.08% -0.13 -0.85 -0.08% -0.25 -1.42 -0.17%
Managed Futures -0.19 -1.47 -0.11% -0.18 -1.43 -0.10% -0.18 -1.29 -0.12%
Multi-Strategy 0.19 1.08 0.11% 0.19 1.07 0.11% -0.12 -0.55 -0.08%
McFadden's R-square 12.8% 12.8% 11.8%
# of Liquidation Funds 765 765 645
# of Observations 134,461 134,461 95,816

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.

Panel A: Liquidation vs. Non-liquidation Funds

Model 1 Model 2
Expected Parameter t-value Marginal Parameter t-value Marginal
Sign Estimate Effect Estimate Effect
Ret[t-6, t-1] (-) -9.81 -5.54 -0.14%
I(Ret[t-6, t-1]<0) (+) 0.35 3.48 0.21%
Investor Impatience[t-1] (+) 0.14 3.09 0.10%
Flow[t-6, t-1] (-) -3.72 -4.20 -0.17%
I(Flow[t-6, t-1]<0) (+) 0.42 4.02 0.26%
Avg # of Missing AUM[t-6, t-1] (+) 1.04 8.69 0.15%
Size[t-1] (-) -0.30 -14.36 -0.33%
Volatility[t-6, t-1] (+) -8.92 -5.59 -0.20%
Ret[t-12, t-7] (-) -5.41 -3.09 -0.08% -1.55 -0.88 -0.02%
I(Ret[t-12, t-7]<0) (+) 0.34 3.34 0.21% 0.22 2.13 0.13%
Investor Impatience[t-7] (+) 0.13 3.17 0.09%
Flow[t-12, t-7] (-) -2.82 -3.43 -0.16% -1.94 -2.69 -0.11%
I(Flow[t-12, t-7]<0) (+) 0.20 2.06 0.12% 0.11 1.15 0.07%
Avg # of Missing AUM[t-12, t-7] (+) 0.64 4.92 0.09%
Size[t-7] (-) -0.26 -12.82 -0.29%
Volatility[t-12, t-7] (+) -3.56 -2.23 -0.08%
Age[t] (+) 4.62 7.04 1.82% 4.30 6.55 1.69%
Age[t]^2 (-) -0.65 -6.77 -1.79% -0.61 -6.32 -1.67%
Redemption Notice Period (-) -0.31 -4.73 -0.17% -0.25 -3.96 -0.14%
Lockup Period (-) -0.11 -2.90 -0.08% -0.10 -2.52 -0.07%
Personal Capital (-) -0.30 -3.93 -0.19% -0.25 -3.20 -0.15%
December (+) 0.84 8.38 0.51% 0.83 8.28 0.51%
Year -0.03 -2.09 -0.05% -0.01 -0.73 -0.02%
Convertible Arbitrage 0.24 1.33 0.14% 0.15 0.87 0.09%
Dedicated Short Bias -0.52 -1.42 -0.32% -0.57 -1.53 -0.35%
Emerging Markets -0.17 -1.18 -0.11% -0.11 -0.78 -0.07%
Equity Market Neutral 0.40 2.99 0.25% 0.35 2.64 0.22%
Event Driven 0.10 0.68 0.06% 0.10 0.72 0.06%
Fixed Income Arbitrage 0.14 0.74 0.09% 0.13 0.70 0.08%
Global Macro 0.00 0.01 0.00% -0.15 -0.92 -0.09%
Managed Futures -0.13 -0.99 -0.08% -0.18 -1.40 -0.11%
Multi-Strategy 0.15 0.83 0.09% 0.20 1.11 0.12%
McFadden's R-square 8.1% 12.6%
# of Liquidation Funds 764 765
# of Observations 123,909 124,548

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.

Panel A: Where failures are predicted by 7-month lagged covariates

A-1: Failure = Liquidation A-2: Failure = Defunct
Failure Remove the bottom Remove the bottom
Remove failure Remove failure
Risk quintile based on quintile based on
month returns month returns
fund size fund size
Low 0.28 0.38 0.36 0.33
(2.89) (3.83) (3.70) (3.53)
Quin2 0.28 0.15 0.25 0.16
(2.62) (1.40) (2.35) (1.47)
Quin3 0.18 0.11 0.19 0.14
(1.68) (0.98) (1.68) (1.23)
Quin4 -0.01 0.00 -0.04 0.02
(-0.09) (-0.02) (-0.36) (0.24)
High -0.30 -0.21 -0.29 -0.23
(-2.59) (-1.83) (-2.56) (-1.96)
L-H 0.58 0.60 0.65 0.56
(4.83) (4.93) (5.68) (5.24)

Panel B: Where failures are predicted by 1-month lagged covariates

B-1: Failure = Liquidation B-2: Failure = Defunct
Failure Remove the bottom Remove the bottom
Remove failure Remove failure
Risk quintile based on quintile based on
month returns month returns
fund size fund size
Low 0.35 0.43 0.36 0.39
(3.44) (4.04) (3.61) (3.74)
Quin2 0.26 0.14 0.21 0.24
(2.38) (1.37) (1.90) (2.39)
Quin3 0.14 0.12 0.23 0.15
(1.30) (1.17) (2.08) (1.38)
Quin4 0.12 0.17 0.06 0.04
(1.04) (1.42) (0.57) (0.31)
High -0.26 -0.25 -0.21 -0.20
(-2.46) (-2.01) (-1.94) (-1.57)
L-H 0.61 0.68 0.58 0.59
(5.39) (5.81) (5.24) (4.88)

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.

Panel A: Failures are predicted by both time-varying and constant covariates

Panel A-1: Failure = Liquidation Panel A-2: Failure = Defunct
Failure Risk
7-month lagged 1-month lagged 7-month lagged 1-month lagged
Low 0.27 0.35 0.36 0.36
(2.85) (3.42) (3.68) (3.58)
Quin2 0.28 0.26 0.24 0.21
(2.59) (2.35) (2.30) (1.90)
Quin3 0.18 0.14 0.17 0.22
(1.67) (1.27) (1.59) (2.00)
Quin4 -0.01 0.11 -0.05 0.04
(-0.12) (1.02) (-0.45) (0.41)
High -0.34 -0.30 -0.35 -0.27
(-2.94) (-2.79) (-3.10) (-2.42)
L-H 0.61 0.65 0.71 0.63
(5.10) (5.62) (6.15) (5.61)

Panel B: Failures are predicted by only time-varying covariates

Panel B-1: Failure = Liquidation Panel B-2: Failure = Defunct
Failure Risk
7-month lagged 1-month lagged 7-month lagged 1-month lagged
Low 0.29 0.26 0.30 0.26
(2.38) (1.95) (2.52) (2.11)
Quin2 0.19 0.26 0.21 0.25
(1.75) (2.06) (1.89) (2.06)
Quin3 0.16 0.21 0.12 0.28
(1.43) (2.07) (1.26) (3.10)
Quin4 -0.07 0.06 -0.07 -0.02
(-0.60) (0.61) (-0.73) (-0.15)
High -0.19 -0.22 -0.18 -0.22
(-1.56) (-2.06) (-1.34) (-1.97)
L-H 0.48 0.48 0.48 0.48
(2.96) (3.23) (3.07) (3.52)

Panel C: Failures are predicted by only constant covariates

Panel C-1: Failure = Liquidation Panel C-2: Failure = Defunct
Failure Risk
7-month lagged 1-month lagged 7-month lagged 1-month lagged
Low 0.35 0.39 0.38 0.43
(3.97) (4.32) (4.25) (4.62)
Quin2 0.24 0.24 0.18 0.19
(2.16) (2.16) (1.76) (1.75)
Quin3 0.11 0.13 0.11 0.14
(1.06) (1.15) (0.90) (1.09)
Quin4 -0.13 -0.12 -0.15 -0.14
(-1.17) (-1.02) (-1.45) (-1.42)
High -0.09 -0.12 -0.02 -0.04
(-0.77) (-0.82) (-0.15) (-0.29)
L-H 0.44 0.51 0.40 0.47
(3.75) (3.65) (3.41) (3.48)

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.

Panel A: Failure = Liquidation

Failure Redemption Notice Period Lockup Period
Risk Short Long No Yes
Low 0.09 0.37 0.23 0.53
(0.70) (3.97) (2.19) (4.29)
Middle -0.11 0.31 0.13 0.26
(-0.90) (2.87) (1.26) (1.93)
High -0.36 0.17 -0.28 0.19
(-2.75) (1.78) (-2.67) (1.03)
L-H 0.46 0.19 0.51 0.34
(2.68) (2.00) (4.82) (1.73)

Panel B: Failure = Defunct

Failure Redemption Notice Period Lockup Period
Risk Short Long No Yes
Low 0.08 0.42 0.23 0.50
(0.56) (4.46) (2.18) (3.61)
Middle -0.13 0.24 0.11 0.18
(-1.13) (2.38) (1.16) (0.94)
High -0.33 0.20 -0.27 0.30
(-2.65) (1.97) (-2.57) (2.73)
L-H 0.41 0.22 0.50 0.20
(2.65) (2.44) (4.94) (1.35)

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.

Fama-MacBeth Cross-Sectional Regression Results

Panel A: Univariate Panel B: Multivariate Regressions
Regressions 7-month lagged 1-month lagged
Variable 7-month lag 1-month lag Liquidation Defunct Liquidation Defunct
Failure Risk[t-k] -0.05** -0.04* -0.05** -0.04**
(-1.99) (-1.81) (-2.23) (-2.14)
Ret[t-m, t-k] 13.73*** 26.18*** 11.71*** 11.92*** 23.59*** 23.70***
(2.79) (4.14) (2.79) (2.86) (3.80) (3.81)
Investor Impatience[t-k] -0.19** -0.25*** -0.05 -0.07 -0.05 -0.06
(-2.38) (-3.97) (-1.00) (-1.30) (-0.75) (-0.82)
Flow[t-m, t-k] -0.15 0.52 -0.66** -0.52 -0.81** -0.69*
(-0.43) (1.22) (-1.98) (-1.49) (-2.07) (-1.75)
Avg # of Missing AUM[t-m, t-k] -0.20* -0.25** -0.13 -0.07 -0.12 -0.11
(-1.70) (-2.13) (-1.02) (-0.60) (-1.08) (-0.98)
Size[t-k] 0.01 0.04 -0.03 -0.02 -0.02 -0.02
(0.41) (1.64) (-0.96) (-0.86) (-0.69) (-0.52)
Volatility[t-m, t-k] 2.06 3.58 2.73 3.09 4.68 4.88
(0.58) (0.91) (0.86) (0.95) (1.30) (1.36)
Age[t] -0.09 -0.11 -0.02 0.00 -0.01 -0.02
(-0.99) (-1.51) (-0.27) (0.03) (-0.08) (-0.21)
Redemption Notice Period 0.18*** 0.18*** 0.05 0.06 0.02 0.04
(4.14) (4.11) (0.82) (0.96) (0.33) (0.91)
Dlock 0.27*** 0.29*** 0.02 0.03 0.06 0.02
(2.67) (2.90) (0.20) (0.36) (0.60) (0.21)
Personal Capital 0.25*** 0.28*** 0.10* 0.12** 0.18*** 0.17***
(3.40) (3.95) (1.85) (2.05) (2.98) (3.20)
Adjusted R-square 12.51% 12.45% 14.64% 14.56%
# of Observations 123,076 133,906 123,076 133,906

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.

Panel A: When failures are predicted by 7-month lagged information

Panel A-1: Failure = Liquidation
Covariate excluded when predicting failures (one at a time)
Ret[t-12,t-7] Impatience[t-7] Redemption Lockup Ownership
Failure Risk[t-7] Estimate -0.05*** -0.06*** -0.04* -0.07*** -0.07***
t-value (-3.77) (-3.65) (-1.92) (-3.76) (-4.13)
Covariate Estimate 12.39** -0.13* 0.14*** 0.14 0.20***
t-value (2.49) (-1.72) (2.96) (1.44) (2.68)

Panel A-2: Failure = Defunct

Covariate excluded when predicting failures (one at a time)
Ret[t-12,t-7] Impatience[t-7] Redemption Lockup Ownership
Failure Risk[t-7] Estimate -0.05*** -0.06*** -0.05** -0.07*** -0.07***
t-value (-3.73) (-4.25) (-2.18) (-3.86) (-4.21)
Covariate Estimate 12.95*** -0.13* 0.14*** 0.12 0.20***
t-value (2.62) (-1.76) (2.91) (1.22) (2.69)

Panel B: When failures are predicted by 1-month lagged information

Panel B-1: Failure = Liquidation
Covariate excluded when predicting failures (one at a time)
Ret[t-12,t-1] Impatience[t-1] Redemption Lockup Ownership
Failure Risk[t-1] Estimate -0.04*** -0.06*** -0.07*** -0.08*** -0.08***
t-value (-2.91) (-3.36) (-2.86) (-4.36) (-4.75)
Covariate Estimate 25.09*** -0.21*** 0.13*** 0.16* 0.25***
t-value (3.89) (-3.13) (2.67) (1.83) (3.64)

Panel B-2: Failure = Defunct

Covariate excluded when predicting failures (one at a time)
Ret[t-12,t-1] Impatience[t-1] Redemption Lockup Ownership
Failure Risk[t-1] Estimate -0.05*** -0.05*** -0.07*** -0.08*** -0.09***
t-value (-3.10) (-3.48) (-3.26) (-4.61) (-5.07)
Covariate Estimate 25.22*** -0.21*** 0.13*** 0.14 0.25***
t-value (3.87) (-3.22) (2.80) (1.56) (3.63)

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)

Ret_full Flow_full Ret_sub1 Flow_sub1 Ret_sub2 Flow_sub2

Panel B: Defunct 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
Time-to-Defunct (months)

Ret_full Flow_full Ret_sub1 Flow_sub1 Ret_sub2 Flow_sub2

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