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Hedge funds are not "normal" institutional investors. They launch proxy fights for corporate control. Their recent successes and "wolf pack" tactics have garnered headlines, but leave us with a question: what does hedge fund activism mean for corporate governance in the United States? This Article undertakes a legal, empirical, and theoretical study in an effort to answer this question. The heart of the Article is an empirical study of obtainable instances of hedge fund activism during 2005 and the 2006 proxy season. The Article starts by showing that the SEC opened the door to hedge fund activism when it stopped censoring most proxy material in 1992 and started allowing proxy "free communication" in 2000. The Article's empirical survey found over 50 instances of hedge fund activism, and also found the in terrorem effect of these examples to be considerable. The survey further found that the combination of "wolf pack" tactics and the increasing influence of activist proxy advisory firms (the recommendations of which many institutional investors follow automatically) have made hedge fund activists a real power in corporate governance. Despite some claims that hedge funds often hold short positions or are otherwise dangerously conflicted, the survey found very limited evidence for this; the survey also found that hedge funds have, in fact, disclosed these conflicts, though the proxy and Williams Act rules in this respect should be clarified. The Article then subjects these results to theoretical analysis using current nexus of contracts, shareholder primacy, director primacy, team production, connected contracts, and other theories, and finds none completely satisfactory. The Article concludes that an almost unprincipled balance-of-power political model best explains the hedge fund activism phenomenon. In the end, if these activities cause managements to review and reassess their strategies, corporate governance is improved.
Hedge funds play an increasingly important role in U.S. Treasury (UST) cash and futures markets, a role that has been widely discussed following the March 2020 U.S. Treasury sell-off. In this note, we analyze hedge funds' holdings of UST securities and their UST market activities in normal times and in times of financial market stress using regulatory data from the SEC Form PF. We also develop an approach to decompose the reported aggregate UST exposures into UST holdings and derivatives exposures.
Our analysis also sheds light on the role of hedge fund UST selling during the March 2020 Treasury market turmoil. We find that large hedge funds' gross Treasury exposures declined by $426 billion in March 2020. After accounting for valuation changes, we estimate that they sold, on net, $173 billion of Treasury securities, and reduced their short derivatives positions by $232 billion. Furthermore, we document that most of the decline in Treasury holdings and short derivatives positions in March was driven by funds likely trading the cash-futures basis. Finally, we show that, although hedge fund selling of Treasury securities in Q1 2020, at just over $170 billion, was sizable, it was not outsized relative to the selling by other types of investors such as the foreign and mutual fund sectors.
Hedge funds are a heterogeneous set of institutions that interact with UST markets in several ways, including as arbitrageurs of different relative-value spreads and as investors in UST securities. As arbitrageurs, hedge funds execute relative-value trades that involve UST exposure on either one (e.g., swap spread arbitrage) or both sides of the relative-value trade (e.g., on/off the run arbitrage, UST cash/futures basis trade). Through their arbitrage activities, hedge funds link related markets including UST cash, futures, and because they typically finance their holdings in repo, UST repo markets. As investors, hedge funds hold UST exposures either as part of a broader investment strategy (e.g., risk parity funds), or as a source of liquidity.
Note: The left panel shows monthly Treasury exposures of qualifying hedge funds, including securities holdings and derivatives exposure. The right panel shows monthly repo exposures of qualifying hedge funds.
What explains the increase in hedge funds' Treasury arbitrage activities between 2018 and 2020? Our analysis suggests that much of the increase is due to the increased popularity of the cash-futures basis trade among hedge funds. Treasury issuance rose following the Tax Cut and Jobs Act (passed November 2017). There was a coincident increase in demand from traditional asset managers for long Treasury duration exposure in futures, which was met by hedge funds.3 As shown in Figure 4, left panel, asset manager long UST futures positions increased notably over this period, about in line with the increase with leveraged fund short UST futures positions. Hedge funds were likely in a better position to meet the demand of asset managers for long UST futures during this period than other potential arbitrageurs such as broker dealers. Although dealer inventories of Treasury securities rose during this period, their selling of UST futures increased only modestly. Dealers' capital and balance sheet costs, internal risk limits, and regulatory constraints such as the SLR/eSLR, which came into effect in 2018, may have limited dealer willingness or capacity to intermediate between Treasury cash and futures markets, increasing the role of non-dealer arbitrageurs including hedge funds.
The Treasury cash-futures basis trade became popular with hedge funds between mid-2018 and February 2020. As demonstrated in Figure 5, this trade involves shorting a UST futures contract and going long a UST note deliverable into that contract, with the note financed by repo. Given low haircuts on Treasury repo and low margin levels on Treasury futures,4 the cash-futures basis trade has the potential to be very highly leveraged. In addition, as repo financing supporting these trades is typically short-term and futures margins can change, arbitrageurs are exposed to margin risk and rollover risk inherent in maintaining the trade.
Although the reported Treasury exposure on Form PF aggregates Treasury holdings and derivatives exposures, we can take advantage of other cross-sectional data available on the form to estimate a monthly fund-level decomposition of reported exposures into holdings and derivatives exposures. This estimation is done for both the long and short exposures. The estimation is based on the reported total UST and other fixed income exposures, and the reported repo and gross derivatives exposures. The intuition behind the algorithm is simple. Short fixed income exposures that are not supported by reverse repo are classified as short derivatives exposures. These exposures are allocated across fixed income instruments based on the reported total exposures for each instrument and assumptions about how these exposures are typically financed. Long fixed income derivatives exposures are estimated as the difference between the reported gross derivatives exposures and the estimated short fixed income derivatives exposures, and then allocated to UST and other fixed income instruments in a similar way as the short exposures. We then define long (short) UST holdings as the difference between the reported long (short) total UST exposures and the estimated long (short) UST derivatives exposures. This estimation procedure allows for the fact that not all of hedge funds' holdings of UST securities are financed in repo, as some Treasury holdings are used as liquidity buffers. Details for the algorithm are available in Appendix 1.
Figure 6 shows the decomposition of QHFs' UST exposures into securities holdings and derivatives exposures. Based on these estimates, securities holdings accounted for 76 percent of hedge funds' long UST exposures in February 2020, or $1.1 trillion, with most of the increase in these exposures taking place prior to the outbreak of the pandemic. In contrast to long UST exposures, most of the short UST exposures are derivatives positions, with short securities positions accounting for only 19 percent, or $179 billion, of short UST exposures as of February 2020.
We follow an algorithm developed by Kruttli et al. (2021) to classify likely basis traders based on how the trade is likely to be reflected in Form PF. Specifically, for each fund, we consider the correlation between the fund's Treasury arbitrage positions, proxied by the long-short balanced part of its Treasury exposure, to its net repo borrowing. The correlations are estimated between January 2018 and February 2020, a period when the basis trade was most popular with hedge funds. If this correlation is positive and statistically significant, and if the fund indicates that it follows either a relative value sovereign strategy or a global macro strategy, then we classify the fund as a likely basis trader.6 Further details are in Appendix 1. We note that, in addition to conducting the basis trade, funds classified as likely basis traders may have had Treasury exposures for other uses or trades.
Under the assumption that all the Treasury exposures of funds classified as likely basis traders were due to that trade, our estimates suggest that the basis trade grew by $400 billion between 2018 and early 2020, accounting for about 2/3 of the increase in qualifying hedge funds' Treasury exposures during that time. Moreover, basis trades came to represent most of the holdings of Treasury securities by hedge funds, an indication that hedge funds were essentially warehousing Treasury securities on behalf of non-hedge fund asset managers.
Treasury market functioning during the March turmoil may have been affected by the activities of relative-value hedge funds. Market commentary at the time pointed to the selling of Treasury positions by hedge funds exiting their basis trades as a major amplifier of the Treasury market dislocations in mid-March. According to Form PF data, long QHF Treasury exposures fell by $252 billion in March 2020, suggesting that hedge fund de-risking may have indeed contributed to the sell-off. These declines in UST exposures likely reflect some combination of outright sales of Treasury securities and reductions in derivatives positions. Large sales of Treasury securities, especially to dealers who were likely already under pressure due to the selling by non-hedge fund clients, would likely have more severe implications for Treasury market functioning than the closing of (typically exchange-traded) derivatives positions. However, due to a lack of detailed data on hedge funds' Treasury cash and derivatives positions, it has thus far been difficult to assess the extent of hedge funds' Treasury selling in March.8 2b1af7f3a8