SidebySide Management of Hedge Funds and Mutual Funds

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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

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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

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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

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Potential Conflicts in Side-by-Side Arrangement

• Differing compensation structures between mutual
  funds and hedge funds create potential conflicts
• Mutual fund managers 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

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Manifestation of the Conflicts

• Front-running hedge fund trades ahead of mutual
  fund trades
• Allocating underpriced IPO shares
  disproportionately to hedge funds
• Stale trades/Timing of mutual fund shares
• It is often hedge funds that benefited

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Policy Debate

• Due to the potential conflicts of interest
  inherent in this arrangement some argue to ban
  the 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
• The last several years has seen an exodus of
  managerial talent from the mutual fund industry
  in search of more money freedom

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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
• Identify the factors that affect management
  companies decision to implement side-by-side
  arrangement

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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

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Number of Side-by-Side Funds and Managers
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Time Trend of Side-by-Side Management (When the
SBS arrangement began)
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Side-By-Side Management by Investment Objectives
Mutual Funds
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Side-By-Side Management by Investment Objectives
Hedge Funds
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Summary Stat for Side-by-Side Mutual Funds
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Summary Stat for Side-by-Side Hedge Funds
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Summary Stat by Investment Objectives Mutual
Funds
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Summary Stat by Investment Objectives Hedge Funds
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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

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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 as during the
  side-by-side period are estimated for funds with
  the same investment objective but w/o
  side-by-side arrangement.

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Side-by-Side Funds vs. Peer Funds
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Portfolio Approach
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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

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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

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Performance of Side-by-Side Funds Regression
Approach
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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 support the industry explanation
  that SBS privileges are granted to the best
  managers for purposes of retention

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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

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Performance of Hedge Funds with Side-by-Side
Arrangements
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Portfolio Approach (6-factor alpha)
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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

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Robustness

• We eliminate all funds from the peer group that
  CRSP lists as team managed because these have
  been shown to under-perform The results are
  unchanged
• We distinguish between cases where the
  SBS-managed mutual and hedge funds are under the
  same parent company and cases where mutual and
  hedge funds are under separate parents SBS funds
  outperform across the board, but strongest when
  under same parent
• We also run our tests in terms of return gaps,
  and again the results are similar

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Limitations and Future Research

• Incomplete identification of side-by-side funds
• Only used one hedge fund data base TASS
• Will include two more HFR Morgan Stanley
• Factors affecting the establishment of
  side-by-side arrangement (Retention?)
• Impact of side-by-side arrangement on the exit
  rate of mutual fund managers