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SidebySide Management of Hedge Funds and Mutual Funds

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Title: SidebySide Management of Hedge Funds and Mutual Funds


1
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

2
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

3
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

4
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

5
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

6
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

7
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

8
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

9
Number of Side-by-Side Funds and Managers
10
Time Trend of Side-by-Side Management (When the
SBS arrangement began)
11
Side-By-Side Management by Investment Objectives
Mutual Funds
12
Side-By-Side Management by Investment Objectives
Hedge Funds
13
Summary Stat for Side-by-Side Mutual Funds
14
Summary Stat for Side-by-Side Hedge Funds
15
Summary Stat by Investment Objectives Mutual
Funds
16
Summary Stat by Investment Objectives Hedge Funds
17
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

18
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.

19
Side-by-Side Funds vs. Peer Funds
20
Portfolio Approach
21
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

22
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

23
Performance of Side-by-Side Funds Regression
Approach
24
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

25
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

26
Performance of Hedge Funds with Side-by-Side
Arrangements
27
Portfolio Approach (6-factor alpha)
28
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

29
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

30
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
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