Houston's Kumar publishes study on hedge fund activism

University of Houston finance professor Praveen Kumar has published a study on hedge fund activism that suggests investment brand can have long-term harm on the economy.

The study, based on 12 years of data from 1,332 firms, will be featured in the January 2016 issue of the Journal of Financial Economics. Among his findings, Kumar suggests that by pouring large investments into specific companies to boost large and rapid growth, the waning competition allows for potentially stagnant standards in the companies that boom.

"It is survival of the fittest,” Kumar said. “Yes, you do want the weakest competitors weeded out. But as they exit, there is less competition and hence, less incentive to innovate for the surviving firms. Over time, consumers and economic growth may be hurt.”

Kumar's study is unique in that it looks primarily at the experience of rival groups and competitors rather than the experience of firms that do best.

The hedge fund investment strategy typically involves investors who buy into a business at levels large enough to gain significant control over that company's strategies and operations. Kumar said these types of investments continue to be made in an aggressive way, most commonly in industries such as finance, real estate, insurance, manufacturing, high tech and retail.

Many finance experts defend hedge fund activism on the basis that it provides a major boost in economic activity and sifts out of the very best management practices and strategies as investors tend to make sweeping, aggressive steps with their targeted companies to see the biggest return in the shortest amount of time, creating new models for efficiency. Kumar cautioned, however, that the benefits are typically limited to the success of one particular company.

“The benefits aren’t percolating to the competition on average,” Kumar said. “Their productivity and investment generally goes down.”

The end result, Kumar said, is highly consolidated markets dominated by small numbers of very successful and highly capitalized companies with large portions of the market share. Kumar added that these companies are also typically not ones invested in by the majority of the investing public, which usually holds shares in the competing companies that did not receive the boost of hedge fund investment. 

This dynamic sets more people up for losses, even if macro-level economic indicators suggest the economy overall is doing well because of the overwhelming growth of hedge fund-supported businesses.

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