If your mutual fund manager is also managing a hedge fund you may not be getting the best deal.
Sometimes called side-by-side management, the practice of having the same managers running mutual funds as well as hedge funds has attracted concern over potential conflicts of interest, as well as increased scrutiny and regulation from the Securities and Exchange Commission.
The worry: asset managers will be tempted by the potential for higher compensation from hedge funds to favour those clients, potentially allocating trades to the detriment of their mutual funds.
As part of an effort to address this and other concerns, the SEC in 2005 put in place mandatory new disclosures. Using data from these disclosures, a new study finds evidence that the mutual funds in side-by-side management arrangements lose out.
“We find that funds with side-by-side managers underperform … peers without side-by-side managers, particularly when a fund’s manager has a greater percentage of their assets under management outside the fund industry or has a relatively performance-insensitive mutual fund clientele,” according to a study by Diane Del Guercio of the University of Oregon, Egemen Genc of Erasmus University Rotterdam and Hai Tran of Loyola Marymount University.
“Overall, our results cast doubt on the effectiveness of the monitoring and governance mechanisms that advisory firms put in place to mitigate the conflicts of interests due to side-by-side management.”
Looking at data from the 30 largest US fund families, which themselves represent about 75% of mutual fund assets, the study found that roughly 7% of managers are simultaneously steering hedge and mutual funds.
Mutual funds with at least one side-by-side manager underperform those without by 9.6bp per month, or 1.15 percentage points a year, using a standard measure of outperformance, or alpha, according to the study. What’s more, the effect was only found when mutual fund managers run hedge money, not in similar arrangements when they run separate pooled accounts.
Funds that switch from not having side-by-side management to having it show even more striking underperformance: about 2.5 percentage points a year.
“We can rule out the alternative explanation that simply adding more assets under management leads to underperformance. Rather, the results specifically point to a performance decline only when the manager begins simultaneous management of a hedge fund,” according to the study.
Agents with conflicts
To be sure, the study sheds no light on whether the underperformance also represents an underperformance against the markets themselves or a broader universe of funds. The promise, or selling proposition, of side-by-side management has been as a talent retention and attraction mechanism for fund managers, who’ve argued that mutual fund clients can benefit by getting access to managers who might otherwise leave them for the greener pastures of the hedge fund industry.
One thing is clear: those managers who do side-by-side management can earn a disproportionate part of their compensation, all else being equal, from the hedge fund side.
An earlier study found that for each incremental dollar earned by hedge fund investors, the typical manager expects a 16 cent reward from incentive fees and the increase in value of their managerial ownership stake. That same dollar of incremental return also drives 23 cents in prospective reward for managers in the form of inflows and growth in future investments. That latter figure is as much as eight times higher than the rewards a mutual fund manager might expect.
The study did find, however, that managers for whom mutual fund money represents an above-median proportion of their funds under management did not display the same lag in performance.
“Managers are presumably reluctant to shift performance away from the mutual fund if poor performance is likely to result in significant outflows and potential career consequences,” according to the study.
While the study does show underperformance, it does not demonstrate how this happens, though the SEC has taken proceedings in past against managers for “cherry picking,” where more profitable trades are allocated to favoured clients.
While investors may simply choose not to invest in mutual funds with side-by-side management, the real need is for better regulation to provide assurance that clients are treated fairly.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
