Side-by-side arrangements: An unequal alliance

(MoneyWatch) Hedge fund managers are supposed to be the superstars of the investment world. Most individual investors don't have access to these gurus, as they don't have the financial resources to qualify as a "sophisticated investor." Mutual fund firms have at least partially solved that problem by creating alliances between hedge funds and mutual funds -- a mutual fund hires a hedge fund manager in what's referred to as a side-by-side arrangement.

The marketing pitch goes something like this: Hedge funds are able to attract the best research analysts, the best traders and so on. This is because the environment is more intellectually stimulating and challenging, their portfolios are less constrained, and their incentive structure (with typical fees of 2 percent annually and a 20 percent share of the profits) provides the opportunity for much greater financial rewards. Mutual funds that mirror these hedge funds allow ordinary investors to tap into that expertise and enjoy the high returns that are supposed to follow.

The authors of the study "Mutual Fund Performance When Parent Firms Simultaneously Manage Hedge Funds" put the theory to the test. The study covered 71 management firms that simultaneously ran 457 actively managed U.S. equity mutual funds side by side hedge funds between 1994 and 2004. The following is a brief summary of their findings:

  • Adjusting for the four factors of stock market risk, small companies, value companies and momentum, mutual funds affiliated with hedge funds underperformed nonaffiliated funds by an economically and statistically significant (at the 5 percent level) 0.48 percent per year.
  • The underperformance wasn't the result of differences in management fees. When expenses were added back to reported returns, side-by-side funds underperformed by 0.53 percent per year.

The authors went on to note that hedge funds typically have much higher expenses, meaning these side-by-side arrangements contain the potential for conflicts of interest that could disadvantage mutual fund investors. For example:

  • Firms can "front-run" the execution of hedge fund trades ahead of mutual fund trades.
  • In a practice known as cherry-picking, decisions about how a trade is allocated can be delayed, with trades experiencing favorable subsequent price movements allocated to hedge funds.
  • Firms can disproportionately allocate more underpriced ("hot") IPO shares to hedge funds and fewer to mutual funds.

They found evidence that favoring trades of the hedge fund over the mutual fund lowered returns for the mutual fund. For example, side-by-side mutual funds appeared to get less of a boost from an underpriced IPO than an unaffiliated mutual fund. The difference was 0.19 percent per year. The contribution of IPO underpricing to differential performance is more striking when they are conditioned on hot and cold IPO markets. During months with the greatest number of IPOs ("hot" months), the difference in performance more than doubled to 0.44 percent per year. Thus the evidence suggests that management firms may have transferred performance from mutual funds to hedge funds.

The authors concluded that the "evidence does not support the hypothesis that affiliations with hedge funds allow side-by-side mutual funds to attract superior stock-picking talent." I would add that while their large fees and incentive structure may allow hedge funds to attract superior talent relative to mutual funds, superior talent hasn't translated into superior returns to investors. Keep this study in mind the next time some broker or adviser pitches you on a side-by-side arrangement that is going to provide you with access to the very best managers that money can buy.

Image courtesy of taxbrackets.org

  • Larry Swedroe On Twitter»

    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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