Why do hedged mutual funds underperform hedge funds? A study of liquidity risk and IPO first-day returns

Abstract: Following the financial crisis, investors have increasingly started to look towards hedged mutual funds providing downside protection in a regulated framework. This is of particular interest to retail investors since the hedged strategies previously have been unavailable to them. Although the hedged mutual funds claim to be running the same strategies as unregulated hedge funds, they deliver inferior returns. The purpose of our essay is to provide explanations for the difference in returns. To do this we run regressions on the returns of both hedge funds and hedged mutual funds using different explanatory variables. Our hypothesizes are that the outperformance can be explained by less liquid holdings of hedge funds and their access to underpriced IPOs. We find that the mutual funds underperform since they fail to benefit from the liquidity premium and, unlike the hedge funds, they do not gain from IPO first-day returns. When controlling for these two factors the two types of funds exhibit no significant difference in performance.