Given the economies of scale — and the opportunities to add more lucrative clients, along with the potential benefits of being able to retain talented money managers — it’s not a surprise that many mutual funds also oversee assets for hedge funds in what’s often referred to as “side-by-side management.” Unfortunately for mutual fund investors, the evidence shows that there are diseconomies of scale in terms of returns. Smaller funds tend to outperform larger ones.
In addition, it has long been recognized that fund sponsors and portfolio managers may have incentives to favor their most lucrative clients over others when opportunities arise, such as when allocating trades across accounts or allocating shares of some hot IPO. The incentives arise because the typical incentive fee component of hedge fund compensation is large (traditionally 20 percent).
Because of concerns over conflicts of interest, in 2005 the SEC mandated new disclosures in annual fund prospectuses that would alert investors to potential conflicts of interest in side-by-side management arrangements and the fund’s policy on mitigating them. (How many investors, however, actually read the prospectus?) Specifically, for each fund manager with day-to-day responsibilities for the fund, the SEC requires disclosure of the number of other accounts concurrently managed, along with their assets under management and the subset of accounts, as well as assets, that pay performance-based fees.
Taking advantage of these required disclosures, Diane Del Guercio, Egemen Genç and Hai Tran, the authors of the May 2016 study Playing Favorites: Conflicts of Interest in Mutual Fund Management, investigated whether side-by-side management harmed or benefited mutual fund performance. Using fund prospectuses from 2005 to 2011, the authors hand-collected data on other accounts managed at the manager level for each active domestic equity mutual fund in the 30 largest fund families, which as of March 2005 accounted for 74 percent of total assets under management in the mutual fund industry.
Interestingly, and likely a surprise to most investors, the authors found that “it is reasonably common for managers to have day-to-day responsibility for assets outside the mutual fund industry. Fifty-seven percent of fund managers manage other pooled investment vehicles and 67% manage other separate accounts…. On average, 76% of a manager’s total assets under management are mutual funds, and therefore 24% are outside the fund industry in pooled investment vehicles and separate accounts.”
These are large figures, highlighting the importance of the study. The following is a summary of the authors’ findings:
- Mutual funds with at least one side-by-side hedge fund manager underperform funds with no side-by-side managers by 9.6 basis points (bps) a month, or 115.2 bps a year, using Carhart alpha (the four investment factors of market beta, size, value and momentum).
- This effect is both statistically (at the 1 percent confidence level) and economically significant, and is robust to various measures.
- Larger hedge funds have more significant underperformance, consistent with the idea that managers have stronger incentives to shift performance away from mutual funds when the potential payoff on the hedge fund side is greater.
- The negative performance effects are unique to funds with side-by-side hedge fund managers. Concurrent management of mutual funds (such as accounts managed on behalf of another fund family through a sub-advisory contract) or separate accounts (typically accounts managed on behalf of large clients, such as defined benefit and defined contribution pension plans or other institutional clients) have no such negative impact.
- Funds that switch (45 funds were identified as “switchers”) from having no side-by-side hedge fund managers to having side-by-side hedge fund managers during the sample period experienced even worse results. Switcher funds underperformed no-side-by-side funds by 21 bps a month (252 bps per year) in Carhart alpha after the switch, while performance before the switch did not significantly differ.
The authors concluded: “These results support the focus on hedge funds in the side-by-side literature, as these are the only account type consistent with a conflict of interest. Moreover, we can rule out the alternative explanation that simply adding more assets under management leads to underperformance. Rather, the results specifically point to a performance decline only when the manager begins simultaneous management of a hedge fund.” They did add that “none of the other mutual funds managed by the same family are measurably affected.”
Also of interest is that the authors found “the underperformance of side-by-side management is effectively mitigated if the manager has an above-median percentage of assets within the mutual fund industry.” And they found the same result if “the manager’s fund has a greater percentage of direct-sold assets, or a lower percentage of broker-sold assets.” It should be no surprise that the negative effect of the manager’s conflict of interest wasn’t apparent when the manager had more to lose if their mutual funds underperformed. Fund sponsors are well aware of evidence showing that direct-sold funds have clients who are more sensitive to past risk-adjusted performance.
As the authors explain: “Managers are presumably reluctant to shift performance away from the mutual fund if poor performance is likely to result in significant outflows and potential career consequences. In sum, our results suggest that counteracting incentives can help alleviate conflicts of interest due to side-by-side management.”
Del Guercio, Genç and Tran also investigated whether side-by-side funds have greater underperformance when the manager has greater opportunities, or discretion, to cross-subsidize. They considered two types of opportunities: the degree of discretionary transactions allowed by the advisory firm and whether a side-by-side fund is managed by either a single manager or a team of managers who all have responsibility for the same hedge fund accounts.
They explain: “The SEC requires advisory firms to disclose in ADV forms whether they engage in transactions where there is potential to benefit themselves or particular clients at the expense of others (e.g., conduct agency cross-trades between different client accounts). Advisors with such policies provide managers with more trade discretion and opportunities to favor the interests of more profitable clients (i.e., hedge funds) over those of other clients such as mutual funds. Moreover, if not all managers on a team share in the benefits accruing to a favored hedge fund, it might be more difficult for the hedge fund manager(s) to gain the tacit cooperation of their fellow mutual fund managers.”
It should be no surprise that the authors found “stronger underperformance in a side-by-side fund if its advisory firm allows greater discretionary transactions, or if the fund is managed by either a single manager or same-team managers.” They concluded: “Together, the results suggest that managers do not favor hedge funds if it is more difficult to do so or if they have greater concerns about the negative consequences of poor mutual fund performance. These results are also suggestive of deliberate cross-subsidization on the manager’s part.” Finally, the authors also concluded that: “Overall, our results cast doubt on the effectiveness of the monitoring and governance mechanisms that advisory firms put in place to mitigate the conflicts of interest due to side-by-side management.”
These findings are of great significance, because the amount of assets in side-by-side agreements is not small. The study’s sample included about 700 domestic equity portfolio managers in any given year, and approximately 7 percent of these managers simultaneously manage hedge funds, representing 12.4 percent of fund-months. If you invest in actively managed funds, do you know if your fund engages in side-by-side agreements?