One of the questions that is often posed to hedge fund managers revolves around the fair allocation of investment ideas to individual funds. If a manager has several funds with varying hurdle rates, performance fees, and management fees, then the manager may have an incentive to funnel her best trade ideas into the one with the most lucrative compensation framework. Add to this the fact that some of those funds might be under their high water mark and some may be home to a disproportionately large personal investment by the manager and investors can get very nervous. The result is often a requirement for a fixed, written policy on trade allocation between funds.
The same kind of conflicts can also exist when a hedge fund manager also manages a mutual fund. Last week we discussed the accelerating phenomenon of “convergence” between hedge funds and traditional long-only funds. We cited an FT article on the possible conflicts resulting from such a practice:
“Nearly half of those surveyed [by consulting firm Cerulli] believed there was no problem in allowing managers to be responsible for both classes of fund, provided the relevant personnel had experience in both and that this was effectively communicated to clients.”
This means that over half of those surveyed believed there may be a problem allowing managers to be responsible for both long-only and hedge funds. But aside from potential conflicts of interest, the question is can long-only and hedge funds be managed side by side? And if they are, do the returns of one or both tend to suffer. The academic research on this topic is somewhat contradictory.
A study conducted in 2006 by Gjergji Cici, Scott Gibson, and Rabih Moussawi concludes that firms managing both hedge funds and mutual funds tend to favor the hedge funds over their less lucrative mutual fund cousins. The authors cite 6 mechanisms for this conflict to exert itself:
- Front running: “…management firms can front run the execution of hedge fund trades ahead of mutual fund trades.”
- Cherry picking: “…decisions about how a trade is allocated can be delayed, with trades experiencing favorable subsequent price movements allocated to hedge funds.”
- Trade allocation: “…rather than allocating the average price paid in a bunched trade, shares bought at the lowest price and shares sold at the highest price can be allocated to hedge funds.”
- Soft dollars: “…mutual funds can pay trade commissions inflated by soft dollar payments, but hedge funds can benefit from services purchased with the soft dollars.”
- IPOs:“…firms can allocate disproportionately more under priced IPO shares to hedge funds.”
- Quid pro quo: “For hedge fund investors who agree to commit assets for extended periods, management firms extend market timing or late trading privileges in the mutual funds they oversee.”
Given this ringing indictment of side-by-side management, you won’t be surprised to learn that the study finds in favor of the plaintiff:
“Our empirical evidence suggests that regulators’ concerns about conflicts of interest are justified…On an annualized basis, side-by-side mutual fund investors as a group earned 124.3 basis points less per year than investors who chose similar unaffiliated funds.”
But hold on a minute. A study released in the spring of 2008 comes to a different conclusion. In “Side by Side Management of Hedge Funds and Mutual Funds” Tom Nohel, Jay Wang, and Lu Zheng find that mutual funds managed by those who also manage hedge funds actually perform significantly better than those that are not.
Rather than examining mutual funds managed by the same firm as hedge funds this study examined the performance of mutual funds managed by the same individual. Any conflicts, surmise the authors, should be even more acute among those particular individuals managing both types of funds.
According to their results, managers of both types of funds do not opportunistically benefit their hedge funds at the expense of their mutual funds. The authors conclude:
“..these results cast doubt on the notion that side-by-side managers are willing/able to benefit their hedge fund investors at the expense of their mutual fund investors. Rather, our findings tend to support those who claim that the opportunity to manage a hedge fund side-by-side with a mutual fund is only granted to star performers.”
They also looked at the hedge funds to see if the performed any differently. It turns out that the hedge fund returns in such a scenario are no worse for wear. In fact, the hedge fund returns of those managers who also run a mutual fund are about the same as those hedge funds managed by pure hedgies.
Nohel, Wang, and Zheng acknowledge the dissonance between their results and the 2006 study. But they also point out that yet another important paper by Vikas Agarwal, Nicole Boyson and Narayan Naik found that “hedged mutual funds” performed poorly except when they were managed by companies that also offered bona fide hedge funds. In other words, the mutual funds benefited from any neighboring hedge funds.
With the inevitable convergence of the long-only and hedge fund worlds, we will likely hear a lot more about the conflicts and performance differences between the two approaches in the coming years. Unfortunately, for now the jury may still be out on whether such marriages are good or bad.