The Mystery of the ‘December Spike’

The following is an extract from the paper “Why is Santa so kind to hedge funds? The December return puzzle!”

Hedge funds are compensated by incentive fees based on annual performance exceeding pre-specified thresholds1. Additionally, better annual performance results in more investor inflows into the fund (Agarwal, Daniel, and Naik, 2004). Hence, there exist strong incentives for managers to improve performance as the year comes to a close. Using a comprehensive database of hedge funds, we for the first time show that December returns of hedge funds are significantly higher than their average returns from January to November (see Figure 1, Panel A). We refer to this as the December spike.

One potential explanation for the December spike, based on risk, is that funds either increase their risk exposures in December or that the factor risk premiums happen to be higher during December in our sample. We find that this risk-based explanation cannot fully explain the December spike, which leaves us with a somewhat more provocative reason that hedge funds are potentially inflating December returns in order to earn higher compensation.

To understand the economic rationale behind the December spike, we focus on two types of incentives faced by hedge fund managers. First one relates to the promise of rewards for good performance. Second one relates to the threat of penalties in the form of capital withdrawal by investors following poor performance. These incentives motivate funds to report better performance. In this paper, we investigate the relation between incentives and the December spike, and show that the spike is driven by incentives to improve performance.

To capture the first set of incentives that reward good performance, we recognise that the performance-based compensation contract provides asymmetric call-option-like payoff. We proxy these incentives by the moneyness and delta (pay-performance sensitivity) of the incentive-fee call option as of November-end. Additionally, incentives arise from the flow-performance sensitivity observed in hedge funds. Agarwal, Daniel, and Naik (2004) show that investors direct more money into funds that perform better relative to its peer group. We proxy these incentives by the performance rank for each fund based on January–November returns relative to its peer group.

To capture the second set of incentives related to penalties for poor performance, we consider lock-up and restriction periods, which determine the severity of threat of capital withdrawals2.  Shorter lock-up and restriction periods imply that investors could withdraw their capital quickly in response to poor performance. Therefore, they act as a disciplining mechanism, which can lead to managers paying excessive attention to short-term performance, thereby providing incentives for returns management. Furthermore, given the flow-performance relation, larger funds that charge higher percentage management fee stand to lose the most from capital withdrawals. Hence, we proxy these incentives by the lockup period, restriction period, and November-end dollar management fee.

In addition to the two types of incentives, arguably funds must also have opportunities to manage returns. For example, funds with higher volatility may be able to hide returns management with greater ease, and therefore may display bigger December spike. Similarly, funds with higher exposure to liquidity risk can more easily influence the security prices to inflate the December returns. In light of this, we proxy the opportunities to manage returns by a fund’s volatility and its exposure to liquidity risk.

Consistent with the above line of reasoning, we find that funds with higher incentives and greater opportunities exhibit bigger December spike. In particular, we find that the December spike is the highest for funds that are in-the-money as of November-end, followed by near-the-money funds, which in turn exceeds that for out-of-money funds. We also find that funds with higher delta and better relative performance at November-end display greater December spike.

These results are consistent with the incentives that reward good performance driving the December spike. Further, we find that funds with shorter lock-up and higher dollar management fee exhibit a higher December spike. This supports the idea that incentives that penalise poor performance also affect the December spike. Finally, we observe that funds with more opportunities, ie, higher volatility and higher liquidity risk, show bigger December spike. The existence of a December spike and its magnitude being correlated with proxies for incentives and opportunities together suggest that hedge funds may be managing their reported returns. This “returns management” phenomenon in hedge funds resembles the well-known “earnings management” phenomenon in corporations.

The evidence of returns management begs the following question: What are the mechanisms by which hedge funds manage their returns? The first mechanism relates to intra-year smoothing of returns, which helps funds to report greater fraction of monthly returns that are positive, an attribute favoured by investors3. This, in turn, can motivate funds to underreport positive returns realised during the early part of the year to create reserves which can be added to future returns if they happen to be negative (“saving for the rainy day”). Any unused reserves get added to the December returns when financial audit takes place at the end of the year. This can potentially give rise to a December spike. The second mechanism relates to funds “borrowing” from their future performance to report higher returns in December in order to earn their incentive fees.

This paper (click here for the complete version) was co-written by Professor Narayan Naik who will be teaching on the Hedge Funds programme in Dubai co-sponsored by the CFA Institute.This advanced level programme has been running in London since 2002 and draws heavily upon the insights provided by ongoing research both at the London Business School BNP Paribas Hedge Fund Centre and other leading universities all over the world.

For more information on the Hedge Funds Dubai programme (to be held from 28 – 31 May 2007), please contact Ms Sinéad Togher via email at or call directly on +44 20 7000 7553+44 20 7000 7553. Alternatively, visit the London Business School website at


1 Incentive fees are based on fund performance over 12 months when net asset value (NAV) exceeds a threshold NAV, which in turn depends on the hurdle rate and high-water mark provisions. With a hurdle rate provision, the manager does not get paid any incentive fee if the fund returns are below the specified hurdle rate, which is usually a cash return like the London Inter-bank Offered Rate (LIBOR). With a high-water mark provision, the manager earns incentive fees only on new profits, i.e., after recovering past losses, if any.

2 Lockup period represents the minimum time the investor has to commit the capital. After the lockup period is over, an investor wishing to withdraw gives advance notice (notice period) and then waits additional time to receive the money (redemption period). Since notice and redemption periods are applied back to back, we combine these two periods, and for expositional convenience simply refer to it as the “restriction period.”

3 Later, we provide evidence in support of this behaviour.