By: Vikas Agarwal, Georgia State University; Nicole Boyson, Northeastern University; Narayan Naik, London Business School
Published: September 26, 2006
We have recently posted on a couple of stories regarding a new breed of “hedged” mutual funds that has emerged as US mutual fund regulators relax rules governing short-selling. In this well-timed research paper academics from the London Business School, Georgia State, Northeastern University in Boston crunch some numbers to get a handle on this phenomenon. They use data from Morningstar and Lipper (both of whom seem to be preparing for an arms race in hedge fund reporting).
They conclude a) that actual hedge funds outperform hedged mutual funds and b) that hedged mutual funds managed by actual hedge fund managers outperform those managed by traditional long-only managers. To explain these phenomenons, the authors propose three hypotheses…
The Strategy Hypothesis
It is often said that the ability to freely invest both long and short provides managers with an opportunity for “double alpha”. The authors of this paper suggest that this ability increases returns regardless of the manager’s previous experience. (See this posting for potential support for this position from personnel at Goldman Sachs and hedge fund manager D.E. Shaw.)
“…due to significant differences in strategy (like the ability to capture alpha on the long as well as the short side and the ability to manage risk better), hedged mutual funds will outperform non-hedge (traditional) mutual funds. We find strong support for the strategy hypothesis. In particular, we find that despite higher fees and turnover, hedged mutual funds outperform traditional mutual funds by about 3% per year, on a fee- and risk-adjusted basis.”
The Skill Hypothesis
So apparently hedged mutual funds outperform long-only mutual funds due to greater strategy flexibility. But before mutual fund providers run out and simply flip the short-selling switch, check this out: in this study, the hedged mutual funds managed by actual hedge fund managers outperformed those managed by traditional long-only mutual fund managers.
“…the subset of hedged mutual fund managers with actual hedge fund experience outperforms those without by about 4.5% per year net of fees.”
“…hedged mutual managers with actual hedge fund experience should be more adept at following the double alpha strategies and therefore should outperform those without such experience. Our results provide strong support to this hypothesis.”
The Regulation & Incentives Hypothesis
Great, say mutual fund managers, all we have to do is hire a few managers with experience running long/short portfolios and give them the tools they need to succeed! But wait. The story isn’t quite over yet. The authors also find that hedged mutual funds – even those managed by actual hedge fund managers – still underperformed real hedge funds. Their hypothesis: real hedge funds face less regulation and different incentives.
“…lighter regulation and better incentives for hedge fund managers are important determinants of hedge funds’ superior performance.”
“Although hedged mutual funds use hedge-fund-like trading strategies, they are regulated by the SEC. As a result, they face certain restrictions such as covering short positions and limiting borrowing to only one-third of total assets. They also have to provide daily liquidity and audited semi-annual reports. In contrast, hedge funds do not face such constraints.”
The study also chalks up hedge fund outperformance to “better incentives to deliver superior performance”. Regular readers of AAA will recognize that this is a complex topic. Performance fees are, by their nature, asymmetric in the manager’s favour. Simply adding more up-side without commensurate downside, ceteris paribus, shouldn’t necessarily lead to “superior performance” (as if the poorly incentivized manager is “holding back”.) We suppose one could argue that all managers have good, alpha-generating ideas in the hopper, but that the risk (both financial and career) of messing up is not appropriately compensated for by management fees alone. Funds with a performance fee, on the other hand, might just be able to coax a manager into making that risky, but profitable bet. (In other words, the hedge fund manager’s risk might be: $1 million bonus vs. job loss, compared to the mutual fund manager’s risk: a pat on the back vs. job loss).
But while this hypothesis may seem to suggest investors should buy an actual hedge fund instead of a hedged mutual fund, the authors make a striking observation that will surely play into the hands of the mutual fund industry as they attack hedge fund fees:
“…on a gross-of-fee basis, hedged mutual funds significantly underperform hedge funds by 5% per year. On a net-of-fee basis as well, hedged mutual funds seem to underperform hedge funds, although the difference is not statistically significant.” (our emphasis)
Hedged Mutual Fund Managers: Fundamentalists?
So “skill” and “flexibility” lead to higher returns. Sounds like good support for the Fundamental Law of Active Management. The authors do cite previous research that seemingly refutes the relationship between investment flexibility and returns, but then propose a happy medium: flexibility begets higher returns only if the increased flexibility is actually meant to increase returns, not if it is only meant to reduce risk or cut transaction costs.
If hedged mutual funds are so great, why haven’t mutual fund companies launched more of them? (The 2004 data used in this study contained only 44 such funds with around US$17 billion in AUM.) And similarly, why on Earth would a hedge fund company want to launch a mutual fund in the face of such terrible odds (which some have done)? Muse the authors:
“There can be several potential explanations. First, it may be that hedge fund managers that also manage mutual funds use their mutual funds as a gateway to attract assets to their hedge funds. Second, it may simply be that it is worth their effort to offer a similar product to a class of investors that are unable to invest in hedge funds. Finally, it is possible that the mutual fund business can subsidize the hedge fund business during bad times, since fees on mutual funds are not performance-dependent. Regardless, the findings of this paper indicate that it is very difficult for mutual funds to outperform hedge funds, even when both employ similar trading strategies.”