Side-by-Side 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 fundmanagers: ~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 of mutual fund trades by hedge funds • Allocating under-priced IPO shares disproportionately to hedge funds • Stale trades/Timing of mutual fund shares • It is often hedge funds that benefited

6. Manifestation of the Conflicts (cont.) • Cherry-picking: • Allocating trades with favorable subsequent price movements to hedge funds • Allocation of bunched trades: • Allocating to hedge funds shares bought (sold) at the lowest (highest) price • Allocation of trade commissions and soft dollars

7. Policy Debate • Due to the potential conflicts of interest, some argue to ban 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 • Ted Truscott of American Express is quoted as saying “To attract the best and brightest, we have to offer the opportunity for side-by-side management” (WSJ, 2004)

8. 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 • Conflicts of interest would suggest that SBS mutual funds would under-perform peers, or SBS hedge funds should outperform peers (or both)

9. Literature on Money Managers and Incentives • There is a sizeable literature showing that mutual fund managers respond to incentives: • Chevalier and Ellison (1997) • Brown, Harlow, and Starks (1996) • Nanda, Wang, and Zheng (2004) • Gaspar, Massa, and Matos (2004) • Reuter (2004) • Massa, Reuter, and Zitzewitz (2006) • Compensation structures encourage strategic allocation of returns between mutual and hedge funds by “side-by-side” managers

10. 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

11. Time Trend of Side-by-Side Management (When the SBS arrangement began)

12. Side-By-Side Management by Investment Objectives: Mutual Funds

13. Side-By-Side Management by Investment Objectives: Hedge Funds

14. Summary Stat by Investment Objectives: Mutual Funds

15. Summary Stat by Investment Objectives: Hedge Funds

16. 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

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

18. Side-by-Side Funds vs. Peer Funds (Mutual Funds)

19. Portfolio Approach (Mutual Funds)

20. 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

21. 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

22. Performance of Side-by-Side Funds: Regression Approach

23. 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 are consistent with the industry explanation that SBS privileges are granted to the best managers for purposes of retention

24. 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

25. Performance of Hedge Funds with Side-by-Side Arrangements

26. Portfolio Approach (6-factor alpha)

27. Robustness • We eliminate all funds from the peer group that CRSP lists as “team managed”. The results are unchanged • Fama-MacBeth controlling for past α: results are qualitatively similar • We also run our tests in terms of “return gaps”, and again the results are similar

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. Limitations and Future Research • Incomplete identification of side-by-side funds • Only used one hedge fund data base: TASS • Will include additional data: HFR • Impact of side-by-side arrangement on the exit rate of mutual fund managers • Factors affecting the establishment of side-by-side arrangement (Retention?)