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

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

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

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

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

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

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

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

Number of Side-by-Side Funds and Managers

Managers Mutual Funds Hedge Funds

Total 112 304 207

Mean --- 2.71 1.85

Median --- 2 1

Max --- 14 9

75% Quantile --- 3 2

25% Quantile --- 1 1

Min --- 1 1

Time Trend of Side-by-Side Management (When the SBS arrangement began)Year Number of Mutual Funds Number of Fund Managers

1990 3 0

1991 5 1

1992 5 3

1993 12 3

1994 11 6

1995 11 7

1996 20 8

1997 27 10

1998 18 6

1999 21 6

2000 44 142001 36 172002 47 152003 25 7

2004 10 5

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

Investment Objectives Number of Mutual Funds

Number of Fund

Managers

Equity USA Growth (GRO) 58 35

Equity USA Small Companies(SCG)

48 29

Equity USA Midcaps (GMC) 25 20

Equity USA AggressiveGrowth (AGG)

21 15

Equity USA Growth & Income(GRI)

20 14

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

Investment Objectives Number of Hedge Funds

Number of Fund

Managers

Long/Short 116 71

Event Driven (Merger Arb) 15 9

Equity Market Neutral 13 9

Fund of Funds 11 4

Emerging Market 10 4

Summary Stat for Side-by-Side Mutual Funds

TNA($Mil)

Total Load(%)

Mgmt Fee(%)

Turnover(%)

Expenses(%)

Mean 793.12 2.29 0.94 106.83 1.68

Median 135.60 2.00 0.97 64.57 1.52

Max 14,000.00 7.62 2.25 720.00 4.40

75% Quantile 580.00 4.38 1.00 140.00 1.90

25% Quantile 37.00 0.00 0.75 28.00 1.28

Min 1.20 0.00 0.15 0.00 0.49

Summary Stat for Side-by-Side Hedge Funds

TNA($Mil)

Incentive Fee (%)

Mgmt Fee(%)

Leverage(%)

Lock-up(months)

Mean 158.51 17.61 1.17 57.98 3.35

Median 54.73 20.00 1.00 0.00 0.00

Max 2549.21 20.00 2.00 888.00 36.00

75% Quantile 143.15 20.00 1.50 102.50 6.00

25% Quantile 15.53 20.00 1.00 0.00 0.00

Min 0.55 0.00 0.00 0.00 0.00

Summary Stat by Investment Objectives: Mutual Funds

Objective TNA ($Mil)

Turnover (%)

Expenses (%)

Mgmt Fee (%)

Mean Mean Mean Mean

GRO Side-by-Side 1183.24 57.56 1.51 0.93

All 1228.13 83.80 1.33 0.73

SCG Side-by-Side 719.09 80.60 1.63 0.99

All 698.12 98.47 1.43 0.84

GMC Side-by-Side 137.03 159.70 1.70 0.88

All 743.28 121.52 1.52 0.75

AGG Side-by-Side 266.91 208.24 2.44 1.17

All 774.05 267.77 1.91 0.90

GRI Side-by-Side 1293.37 56.30 1.64 0.76

All 2120.51 58.54 1.03 0.54

Summary Stat by Investment Objectives: Hedge Funds

Objective TNA ($Mil)

Mgmt Fee (%)

Incentive Fee (%)

Leverage (%)

Mean Mean Mean Mean

Long Side-by-Side 154.75 1.09 18.75 42.40

Short All 271.10 1.29 19.12 39.64

Event Side-by-Side 62.61 1.21 18.73 73.96

Driven All 481.20 1.37 18.83 55.24

Market Side-by-Side 122.64 1.12 20.00 53.09

Neutral All 199.10 1.38 19.53 75.06

Fund of Side-by-Side 108.69 1.60 3.64 0.00

Funds All 351.77 1.44 9.15 24.03

Emerg. Side-by-Side 386.38 1.62 13.50 0.00

Markets All 190.09 1.53 17.58 26.51

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

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.

Side-by-Side Funds vs. Peer FundsSharpe Ratio 4-Factor Alpha

Mean Median Mean Median

Side-by-Side Funds 0.139***(0.00)

0.155***(0.00)

0.044%(0.22)

0.033%(0.31)

Funds with SameInvestment Objectives

0.108***(0.00)

0.103***(0.00)

-0.087%***(0.00)

-0.085%***(0.00)

Performance Difference(Average across funds)

0.032***(0.00)

0.040***(0.00)

0.132%***(0.00)

0.080%***(0.00)

Performance Difference(average acrossmanagers)

0.026***(0.00)

0.033***(0.00)

0.076%**(0.04)

0.045%*(0.06)

Portfolio Approach

Alpha Market SMB HML MOM

Side-by-Side

0.072(0.32)

0.783***(0.00)

0.197***(0.00)

0.144***(0.00)

0.024*(0.10)

No side-by-side

-0.077*(0.08)

0.710***(0.00)

0.084***(0.00)

0.074***(0.00)

0.016*(0.06)

Difference 0.148***(0.00)

0.073***(0.00)

0.113***(0.00)

0.070***(0.00)

0.008(0.45)

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

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

Performance of Side-by-Side Funds: Regression Approach

Four-Factor Adjusted Return (t)

All Funds Equity Funds

Side-by-side Indicator 0.136***(0.00)

0.154***(0.00)

Pre-Side-by-side Indicator 0.125***(0.00)

0.106***(0.00)

Log Fund TNA (t-1) -0.002(0.87)

-0.010(0.55)

Log Family TNA (t-1) 0.004(0.52)

0.006(0.36)

Log Fund Age (t-12) -0.016(0.47)

-0.018(0.46)

Expenses (t-12) -8.892***(0.00)

-9.382***(0.00)

Time fixed-effect Included Included

Style fixed-effect Included Included

Observations 519,872 385,136

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

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

Performance of Hedge Funds with Side-by-Side Arrangements

Sharpe Ratio 6-Factor Alpha

Mean Median Mean Median

Side-by-Side Funds 0.182***(0.00)

0.174***(0.00)

0.222*%(0.08)

0.167%**(0.02)

Funds with SameInvestment Objectives

0.236***(0.00)

0.204***(0.00)

0.306%***(0.00)

0.330%***(0.00)

Performance Difference(Average across funds)

-0.054***(0.00)

-0.060***(0.00)

-0.085%(0.50)

-0.106%(0.13)

Performance Difference(Average across

managers)

-0.053***(0.00)

-0.054***(0.00)

-0.159(0.28)

-0.059(0.27)

Portfolio Approach (6-factor alpha)

Alpha Market SMB HML MOM

Side-by-Side

0.232(0.12)

0.486***(0.00)

0.132***(0.00)

0.157***(0.00)

0.106***(0.00)

No side-by-side

0.352***(0.00)

0.295***(0.00)

0.080***(0.00)

0.069**(0.04)

0.076***(0.00)

Difference -0.12(0.23)

0.191***(0.00)

0.052**(0.02)

0.087***(0.00)

0.030**(0.03)

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

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

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