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Side-by-Side Management of Hedge Funds and Mutual Funds. Tom Nohel, Loyola University Z. Jay Wang, University of Illinois Lu Zheng, University of California at Irvine. Introduction. In recent years the “mutual fund scandal” has been much in the news

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side by side management of hedge funds and mutual funds

Side-by-Side Management of Hedge Funds and Mutual Funds

Tom Nohel, Loyola University

Z. Jay Wang, University of Illinois

Lu Zheng, University of California at Irvine

introduction
Introduction
  • In recent years the “mutual fund scandal” has been much in the news
  • The focus has been on stale trades, lack of independent directors of mutual funds, and conflicts of interest in general
  • At the same time, the scrutiny leveled on the mutual fund industry is starting to shine a spotlight on the hedge fund industry, especially given the tremendous growth in hedge fund assets
policy concerns
Policy Concerns
  • Among the concerns of the SEC and legislators in Washington is the practice of having the same individual(s) manage a mutual fund and a hedge fund --- side-by-side management
    • Wellington manages the $18 billion Vanguard Healthcare fund and offers a healthcare hedge fund managed by the same person (Edward P. Owens)
  • Several well-known mutual fund companies have such arrangements
    • e.g., Alliance Capital, Invesco, American Express
  • Others forbid the practice due to fears of conflicts of interest
    • Fidelity
potential conflicts in side by side arrangement
Potential Conflicts in Side-by-Side Arrangement
  • Differing compensation structures between mutual funds and hedge funds create potential conflicts:
    • Mutual fundmanagers: ~1% of assets
    • Hedge fund managers: 1-2% of assets + a performance fee (typically ~20% of profits)
  • Thus manager has an incentive to benefit his hedge fund at the expense of mutual fund investors
manifestation of the conflicts
Manifestation of the Conflicts
  • Front-running of mutual fund trades by hedge funds
  • Allocating under-priced IPO shares disproportionately to hedge funds
  • Stale trades/Timing of mutual fund shares
    • It is often hedge funds that benefited
manifestation of the conflicts cont
Manifestation of the Conflicts (cont.)
  • Cherry-picking:
    • Allocating trades with favorable subsequent price movements to hedge funds
  • Allocation of bunched trades:
    • Allocating to hedge funds shares bought (sold) at the lowest (highest) price
  • Allocation of trade commissions and soft dollars
policy debate
Policy Debate
  • Due to the potential conflicts of interest, some argue to ban side-by-side arrangements
  • Fund companies that allow this practice argue that without the lure of the possibility to run a hedge fund the best managers will leave
    • Ted Truscott of American Express is quoted as saying “To attract the best and brightest, we have to offer the opportunity for side-by-side management” (WSJ, 2004)
our attempt to inform this debate
Our Attempt to Inform This Debate
  • Document the status and evolution of side-by-side arrangement
  • Analyze the welfare consequences of side-by-side arrangement
    • Test for abnormal performance on mutual fund side
    • Test for abnormal performance on hedge fund side
  • Conflicts of interest would suggest that SBS mutual funds would under-perform peers, or SBS hedge funds should outperform peers (or both)
literature on money managers and incentives
Literature on Money Managers and Incentives
  • There is a sizeable literature showing that mutual fund managers respond to incentives:
    • Chevalier and Ellison (1997)
    • Brown, Harlow, and Starks (1996)
    • Nanda, Wang, and Zheng (2004)
    • Gaspar, Massa, and Matos (2004)
    • Reuter (2004)
    • Massa, Reuter, and Zitzewitz (2006)
  • Compensation structures encourage strategic allocation of returns between mutual and hedge funds by “side-by-side” managers
data summary statistics
Data & Summary Statistics
  • Data sources:
    • CRSP Mutual Fund Database
    • TASS Hedge Fund Database from Tremont
  • Construct a unique data set of side-by-side funds by matching the managers’ names from the two databases.
    • A total of 112 side-by-side managers who manage 304 mutual funds and 207 hedge funds simultaneously.
    • This covers the period 1990-2005
summarizing
Summarizing …
  • Side-by-side management experienced some rapid growth in the late 1990s and early 2000s, and slowed down after 2002
    • $123 billion under management as of 2004(in mutual funds)
  • Most side-by-side mutual funds are growth oriented US equity funds
  • Side-by-side funds have significantly higher expense ratios and management fees than their peers
  • Side-by-side hedge funds look like their peers, though in general smaller
performance tests side by side funds vs peer funds mutual funds
Performance Tests: Side-by-Side Funds vs. Peer Funds (Mutual Funds)
  • Side-by-Side Funds:
    • Sharpe ratios and 4-factor alphas are estimated over the entire side-by-side period based on monthly observations (a period of no less than two years).
    • 235 Mutual funds have enough data to be included
  • Peer Funds:
    • Average Sharpe Ratios and 4-factor α’s during the side-by-side period are estimated for funds with the same investment objective but w/o side-by-side arrangement.
summary and interpretation
Summary and Interpretation
  • Side-by-side funds significantly outperform peer funds
    • A bit over 1.5% in 4-factor alpha on an annual basis.
    • Applied to the $123 billion under management in 2004, this translates to ~$2 billion!
  • The superior performance of side-by-side funds is consistent with the existence of a selection bias
    • Side-by-side arrangement is rewarded to better skilled managers for superior performance
  • However, this does not preclude the existence of conflicts of interest
does the side by side relationship curtail performance
Does The Side-by-Side Relationship Curtail Performance?
  • We run a pooled regression with four factor alpha as the dependent variable that allows us to control for fund size, family size, expenses, turnover, and fixed effects for style and time
  • We also include a side-by-side dummy and a pre SBS dummy
  • These dummies allow us to compare the performance of our side-by-side managers before the SBS relationship and while the SBS relationship was in place
does the side by side relationship curtail performance no
Does The Side-by-Side Relationship Curtail Performance? NO!
  • Our SBS managers appear to be star performers prior to the SBS relationship
  • Moreover, if anything, their performance is even better once the SBS relationship is in place
  • These results are consistent with the industry explanation that SBS privileges are granted to the best managers for purposes of retention
hedge fund performance
Hedge Fund Performance
  • We test for abnormal performance on the hedge fund side
  • Similar to Mutual Fund tests except that we use 6-factor alpha to account for left tail risk in hedge funds
  • Conflicts of interest should lead to superior performance on the hedge fund side
  • Concern over selection bias in hedge fund data
    • Hedge fund data is reported voluntarily, implying that managers with poor track records may not want to report performance
robustness
Robustness
  • We eliminate all funds from the peer group that CRSP lists as “team managed”. The results are unchanged
  • Fama-MacBeth controlling for past α: results are qualitatively similar
  • We also run our tests in terms of “return gaps”, and again the results are similar
summary
Summary
  • Side-by-side mutual funds significantly outperform their peer funds
    • Consistent with self selection: Better ability managers are managing side-by-side funds.
  • Pooled regression shows evidence consistent with high ability managers continuing to outperform their peers
  • On the hedge fund side, side-by-side managers are at best on par with peers, further weakening the case for presence of conflicts of interest
  • Despite potential conflicts of interest in side-by-side relationship, no evidence so far suggesting a significant loss in investor welfare
limitations and future research
Limitations and Future Research
  • Incomplete identification of side-by-side funds
    • Only used one hedge fund data base: TASS
    • Will include additional data: HFR
  • Impact of side-by-side arrangement on the exit rate of mutual fund managers
  • Factors affecting the establishment of side-by-side arrangement (Retention?)