One of the most well-worn clichés in the hedge fund industry is the phrase “skin in the game.” Investors want managers who have “skin in the game,” that is, managers who risk/hedge their own money the same way they are risking/investing their outside investors’ money.
A recent paper by Arpit Gupta of the NYU School of Business and Kunal Sachdeva of Columbia Business School looks at the issue of the value of such skin empirically. Its findings support a meta-cliché: that clichés become clichés because they’re true.
Investors should be wary of the fact that managers with a variety of funds have their skin in some of their ‘games’ but not others, and that investors in those ‘others’ can find themselves at a disadvantage. For example, the Gupta/Sachdeva article cites a Bloomberg story from last November to the effect that Renaissance Technologies “prioritizes strategies with greater excess returns” and leaves those to its Medallion Fund, which has a lot of insider participation. Separately, strategies with lower returns become the domain of “other funds in the family characterized by greater outside investor participation and lower fees.”
Early on, too, the authors of the NYU study quote an observation by Mary Jo White, the SEC chair, from almost two years ago. She said, referring to the work of her agency’ examiners, that they believe “some hedge fund advisers my not be adequately disclosing conflicts relating to advisers’ proprietary funds and the personal accounts of their portfolio managers” such as the allocation of “profitable trades and investment opportunities to proprietary funds rather than client accounts in contravention of existing policies and procedures.”
In the course of determining whether what everybody knows is true, whether investors really should want their managers to have “skin,” Gupta and Sachdeva create a model for managerial activity, building on one created by Jonathan Berk and Richard Green in 2004.
Beck and Green argued (against other scholars who had maintained that only ‘behavioral’ non-rational explanations can account for the compensation of wealth managers generally), that managerial compensation in the mutual funds market in particular is “generally consistent with a rational and competitive market for capital investment and with rational self-interested choices by fund managers who have differential ability to generate abnormal returns.”
So Gupta and Sachdeva build on the Beck and Green model with hedge funds in mind, adding considerations that “capture institutional features of compensation structures” in the hedge fund world. For example, they stipulate that managers “face capacity constraints in determining the optimum level of invested capital, can choose to endogenously create new fund different strategies, and can allocate internal capital across funds.”
Model Testing and Verification
Gupta and Sachdeva then proceed like classic empiricists: they derive predictions from their model and test those predictions. There are three key predictions:
• Inside investment will be concentrated in particular funds within a family of funds;
• Funds with a greater percentage of inside investment will be smaller, because they will be further from the capacity constraint; and
• Funds with greater insider participation result in higher alphas by better aligning the incentives of managers and investors.
The data, they find, supports the model and its predictions. The cliché is true, and as a consequence the much-discussed conflict of interest when a firm manages a family of funds, with differing levels of inside participation, is a real one.
Importantly, Gupta and Sachdeva find that the data is consistent with the proposition that hedge fund managers internalize the problem of scalability, or capacity constraints, better when their own money is at stake, and that as a consequence the insider-stocked funds are smaller than they would be if they were mostly outsider-stocked funds.
Compensation, Scale, and Inequality
Gupta and Sachdeva also reference an article by Steven Kaplan and Joshua Raugh that appeared in the Journal of Economic Perspectives in 2013. Kaplan and Raugh addressed the politically hot topic of why inequality of income and wealth is on the rise. They argued that the explanation is largely to be found in the importance of sale and skill-biased technological change in determining who the 1% are. In this context, those who remain within or who break into the top 1% are often “superstars,” those who manage to perform on a larger scale than their peers, applying their talent to greater pools of resources.
Gupta and Sachdeva agree with Kaplan and Raugh that “managerial rents” have driven top-end wealth and thus income inequality. They add that the option of “deploying their own capital in funds they manage” has been part of the process by which the superstars of finance ensure that they are well rewarded for their stardom.