For Better or Worse? Mutual Funds in Side-by-Side Management Relationships with Hedge Funds

1. For Better or Worse? Mutual Funds in Side-by-Side Management Relationships with Hedge Funds Gjergji Cici, Scott Gibson,and Rabih Moussawi

2. Motivation>>> Design >>> Returns >>> IPO Allocations >>> Conclusion Agency problems in delegated portfolio management • Performance transfers that benefit one group of investors at expense of another group • Management firm benefits from increased fee income

3. Motivation>>> Design >>> Returns >>> IPO Allocations >>> Conclusion Prior evidence consistent with favoritism • Within specific mutual fund • Late traders benefit at expense of long-term investors (Zitzewitz, 2006) • Within mutual fund family • Favored fund investors benefit at expense of other investors (Gaspar, Massa and Matos, 2006) • Younger aged • Higher fee • Strong year-to-date performers

4. Motivation>>> Design >>> Returns >>> IPO Allocations >>> Conclusion Evidence of favoritism that extends beyond mutual fund family? • Firms that run both mutual funds and hedge funds • Mutual fund management fees • Fixed percentage of assets • Hedge fund management fees • Fixed percentage of assets • Performance-based fee

5. Over 1994 to 2004: 71 firms running 457 actively-managed U.S. equity mutual funds During 2004: $448 billion under management Motivation>>> Design >>> Returns >>> IPO Allocations >>> Conclusion Dollar amounts are substantial

6. Motivation >>> Design >>> Returns >>> IPO Allocations >>> Conclusion Potential mechanisms for transferring performance • Front running • Cherry picking • Unbalanced bunched trade allocations • Inequitable commission and soft dollar allocations • Preferential IPO allocations • Nevis Capital Management (Q2-Q4 1999: -5.0%, -3.7, 41% vs. 90.1%, 154.6%, 286.5%) • Quid pro quo market timing or late trading privileges • Alliance Capital

7. Motivation >>> Design >>> Returns >>> IPO Allocations >>> Conclusion Data unavailable to design direct tests:Indirect evidence? • Reported Returns • Return Decomposition • Holdings Returns • Return Gaps • IPO Contribution to Performance

8. Motivation >>> Design >>> Returns >>> IPO Allocations >>> Conclusion Table 4Regression Results

9. Motivation >>> Design >>> Returns >>> IPO Allocations >>> Conclusion Table 4Regression Results

10. Motivation >>> Design >>> Returns >>> IPO Allocations >>> Conclusion Table 4Regression Results

11. Motivation >>> Design >>> Returns >>> IPO Allocations >>> Conclusion Table 5Persistence of the Return Gap

12. Motivation >>> Design >>> Returns >>> IPO Allocations >>> Conclusion IPO contribution to performance • IPO contribution to performance • Gaspar, Massa, and Matos (2006) • Versus matched mutual funds

13. Motivation >>> Design >>> Returns >>> IPO Allocations >>> Conclusion Table 6IPO Contribution to Performance

14. Reported return underperformance 4.3 bp per month Return gap underperformance 3.0 bp per month Return gap persistence 12.60 bp per month for low quintile Lower IPO contribution to performance 1.6 bp per month Evidence does not rule out favoritism Motivation >>> Design >>> Returns >>> IPO Allocations >>> Conclusion Summary of results

15. Motivation >>> Design >>> Returns >>> IPO Allocations >>> Conclusion Normative implications • Strengthen conflicts-of-interest policies • Increased reporting transparency