Why Is Santa So Kind to Hedge Funds? The December Return Puzzle!



We find that the average hedge fund returns during December are significantly higher than thoseduring the rest of the year. This December spike cannot be fully explained by increase in thefunds’ risk exposures and by higher factor risk premiums in December. We argue that hedgefund contractual features such as performance-linked fee, lockup period, notice period, andredemption period, provide incentives to inflate returns at year-end. Consistent with this notion,we find that the spike is indeed more pronounced among funds with higher incentives. Inaddition to incentives, we contend that funds with greater opportunities to manage returns, i.e.,those with higher volatility and higher exposure to liquidity risk, exhibit greater spike. We findthat the spike is indeed higher for funds with greater opportunities to manage returns. Finally, wedemonstrate that funds engage in returns management by under-reporting returns earlier in theyear and/or by borrowing from January returns in the following year.


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Peter Roosenboom