Popular mythology often tells the tale of a disgruntled mutual fund manager who strikes out on his or her own and starts a (more lucrative) hedge fund business.  The existing hedge fund community often retorts that mutual fund managers simply don’t have the training (read “short selling”) experience to manage a hedge fund.

Is this just marketing bravado?  Or is it true that mutual fund managers are no good at managing hedge funds.

More importantly for policy makers, does a mutual fund manager do a disservice to their investors by running a hedge fund on the side?  After all, wouldn’t the much lauded “alignment of interests” inherent in hedge fund contracts give the manager an incentive to funnel their best trades and ideas to the “2 and 20″ hedge fund?

Counter-intuitively, a new study by Tom Nohel of Loyola University, Z. Jay Wang of the University of Illinois and Lu Zheng of UC Irvine actually concludes that managers of “side-by-side” hedge funds and mutual funds actually tend to deliver better mutual fund returns than those who manage only mutual funds.  In other words, the possibility of nefarious trade allocations invoked by hedge fund antagonists is not only a red herring, but the exact opposite may be true.

Regular readers may recall this 2006 study by Gjergji Cici, Scott Gibson, and Rabih Moussawi that shows that companies (not managers themselves) that provide both hedge funds and mutual funds tend to deliver lower mutual fund returns.  To explain this phenomenon, Cici et al outline 6 potential conflicts of interest faced by these companies (front running, trade allocations, soft dollars etc.)

AllAboutAlpha-philes may also remember this paper on “hedged mutual funds” by Vikas Agarwal, Nicole Boyson, and Narayan Naik.  Agarwal, Boyson and Naik found that mutual fund companies running hedge funds in mutual fund wrappers deliver sub-par returns unless they also run a bona fide hedge fund.

This new study seems to conflict with Cici et al and, to some extent, support Agarwal et al’s finding that managing a hedge fund on the side is good for mutual fund unit holders.

In any event, the authors of the new study create a portfolio of mutual funds managed by “side-by-side” managers (those managing both mutual and hedge funds) and a portfolio of mutual funds managed by individuals whose sole focus is the mutual fund.  Similarly, they create a portfolio of hedge funds managed by “side-by-side” managers and one of hedge funds managed by pure-play hedge fund managers.

When they compared the 4-factor alphas of the mutual fund portfolios and 7-factor alphas of the hedge fund portfolios, here’s what they found:

Ironically, the mutual funds managed by those individuals who also managed a hedge fund produced better returns than those managed by mutual fund managers who did not also manage a hedge fund.  So much for conflicts of interest, we suppose.

In fact, regulators might take note that it’s the high net worth hedge fund investors, not the mom and pop mutual fund investors that are worse off when mutual fund managers stray into Hedgistan.

So why would a mutual managed by the same person simultaneously managing a hedge fund do better than their more focused industry colleagues?  Nohel, Wang and Zheng have a few theories…

First and foremost, they suggest that the theory that the hedge fund industry attracts high talent may have some legs.  Writes the trio:

“Our evidence supports the idea that the privilege of running a hedge fund is primarily granted to the most skilled mutual fund managers, especially given that the superior performance we document is driven by managers whose careers began in the mutual fund industry.”

In other words, an opportunity to manage a hedge fund is being used as “means of retention” by mutual fund companies.

They also hypothesize that when mutual fund managers start managing hedge funds on the side, any incentive to funnel trades and ideas to the higher-fee hedge fund is mitigates by the concern for losing their reputations as stellar mutual fund managers.

But rest assured, hedge fund marketers, this study found that “side-by-side” hedge fund managers that came from the mutual fund world delivered lower hedge fund returns than those managers who cut their teeth on hedge funds…

“…those that began as hedge fund managers had insignificant alphas of 0.081% per month relative to their peers, while those that began as mutual fund managers significantly underperformed their peers by -0.282%.”

But wait.  It also turns out that mutual funds managed by “side-by-side” managers from the mutual fund industry performed better than mutual funds managed by managers from the hedge fund industry…

“…side-by-side managers that began as mutual fund managers generated alphas of 0.094% per month or about 1.13% per year and highly significant, while side-by-side managers who began their careers as hedge fund managers generated insignificant alphas of 0.01% per month.”

So the somewhat anti-climatic conclusion is sure to please both camps:  Mutual fund managers deliver better mutual fund returns, and hedge fund managers deliver better hedge fund returns.

A final note:  Check out table 2 of the paper, comparing the characteristics of side-by-side and pure play mutual funds.  The side-by-side funds are: smaller, more expensive, and have a higher turn-over than the pure play funds.  That makes intuitive sense if you believe the “hedge fund culture” might work its way into mutual fund terms.

But what is somewhat surprising is that side-by-side hedge funds have a higher performance fee and a longer lock-up than pure play hedge funds. (Although as you might guess, they have a lower management fee than pure play hedge funds.)

With the explosion of hunters searching for the same scarce alpha and the proliferation of high-frequency trading, is asset management still all about alpha?  Yes, says Jane Li, CAIA, of  FundQuest, a division of BNP Paribas.  Her research of over 10,000 mutual funds (both alive and dead) collectively managing $4  trillion shows that it depends on which category of fund you’re talking about.

Special to AllAboutAlpha.com by: Jane Li, CFA, CAIA, Manager, Investment Management & Research Team, FundQuest

Many argue that more efficient financial markets permanently reduce the potential for managers to produce bona fide alpha.  For example, the author of “Illegal Alpha,” published on AllAboutAlpha.com in November suggested that

“…nowadays talk of alpha generation and alpha-beta separation still permeates, though the search for it – and expectations of finding it – has greatly diminished.”

I disagree.  In fact, following the significant out-performance of many active managers over their passive peers in 2009, it seems logical that investors will rekindle their passion for searching for alpha.

The most important criterion for choosing between a passive or active product is whether active managers are able to add value by generating real alpha. Real alpha is the additional return truly stemming from the unique ability and skill set of the investment manager.

In early 2009, I authored the FundQuest study, What Now?Active or Passive Management? Examining Real Alpha and Exotic Beta. The study analyzed 30,435 U.S.-domiciled non-index mutual funds in 60 categories representing almost $4 trillion of US and non-US assets as of the end of 2008.  It included all live and obsolete mutual funds in the Morningstar database to minimize survivorship bias. Mutual funds were analyzed for the 15-year period from January 1, 1994 to December 31, 2008. Each fund’s behavior pattern and performance was analyzed for 13 rolling 3-year trailing periods ending December 31, 2008.

The study’s main conclusion was that we should not paint either active or passive investments with a broad stroke, as both types of investments have their strengths and weakness.

Importantly, there is very wide variation in the relative performance of either active or passive management from one style category to another. In some style categories, a high proportion of active managers consistently beat index-based investments while in others, very few active managers justified the additional management expenses.

The study also analyzed mutual fund performance patterns in different market environments. The 15-year period was divided into two groups based on market conditions: the bull markets of 1994-1999 and 2003-2007, and the bear markets of 2000-2002 and 2008. The asset-weighted average exotic beta and real alpha of each category for each market condition was also calculated.

Generally, active managers generated more real alpha in bull markets and lower real alpha in bear markets. In aggregate bull markets, the real alpha generated by the entire universe was 0.44 higher than that in bear markets. Specifically, 38 out of 60 categories generated more real alpha in bull markets, while 24 out of 60 categories held relative strength in bear markets. Many growth categories performed better in bull markets, while some value categories generated more real alpha in bear markets. Details are provided in the following chart. As shown below, eight categories generated positive real alpha (>0.5) in both bull and bear markets.

In all, 19 categories of funds generated positive real alpha in bull markets and 12 categories generated positive real alpha in bear markets.

It appears from these findings that active management (in the form of mutual funds in this study) still produces alpha – particularly in niche strategies that may rely more on exploiting informational inefficiencies.  While the “expectations of finding alpha” may be somewhat “diminished,” the reality appears to be that alpha continues to exist.

We’ll see if this hypothesis holds up.  Our next study will be published in the first half of 2010.

- Jane Li, January 2010

The rush is on this year for alternative investment firms to set up and launch both offshore and onshore versions of Undertakings for Collective Investments in Transferable Securities, or UCITS- and NEWCITS-based funds.

According to a late-December report by London-based KdK Asset Management, some 80% of hedge funds, and in particular funds of funds surveyed by the firm expect to launch a UCITS-based this year (see graph by KdK below) as a way to ensure they are on a regulatory par with more traditional, and accessible, European vehicles. More…

Hedge funds: you either love ‘em or hate ‘em, right?

Well, it appears that investors and commentators may actually love them and hate them at the same time.  As Wikipedia defines a “love-hate relationship:”

“…a personal relationship involving simultaneous or alternating emotions of love and enmity. This relationship does not have to be of a romantic nature, and may be instead of a sibling one. It may occur when people have completely lost the intimacy within a loving relationship, yet still retain some passion for, or perhaps some commitment to, each other.”

It seems that every January, there is a proliferation of media stories about how – despite their apparent disdain for hedge funds -  investors show a commitment to hedge funds by clamoring to mimic them through either a) hedge fund replication products or b) “hedged” mutual funds. More…

A common occurrence in the hedge fund-a-go-go days of yore was daily headlines announcing yet another prop desk trader or mutual fund manager “hanging their own shingle” to set up a hedge fund shop or join one. A look at this oldie but goodie by New York Magazine’s Steve Fishman published in May 2005 is case in point.

Beyond lucrative returns, more lucrative potential compensation and the chance to tout being a “hedge fund manager” at the local nightclub, the basic premise for most breaking out on their own was the freedom and flexibility of being the higher up, and not having to bow to one. More…

Readers of the FT over the weekend learned that “a new breed of hedged mutuals grows apace.”  The paper reports that investor demands for liquidity and transparency in hedge funds have forced managers to “try something different.”

But as regular AAA readers are aware, the convergence of hedge funds and mutual funds have been occurring for several years (see end of this post).  In fact, we covered a seminal paper on this subject 3 years ago.  In “Hedge funds for retail investors? An examination of hedged mutual funds” Vikas Agarwal, Nicole Boyson, and Narayan Naik wrote:

“Recently a number of mutual fund companies have begun offering mutual funds that emulate hedge fund strategies, with assets tripling since 2002…over half of the Registered Investment Advisers who do not currently use hedge funds for their clients would add hedged mutual funds to their portfolios.”

The trio concluded that hedge fund managers seemed to be more adept at, well, managing hedge funds:

“…using hedge fund strategies, even within the constraints of the mutual fund environment, can significantly improve performance.”

While “hedged mutual funds” may not be that new, the Madoff Affair may have certainly made them more interesting to retail investors.

A new report by BNY Mellon’s Pershing Prime Services unit and consultancy Finadium (“Competition and Convergence: The Evolving Landscape for Hedge Funds” – available here with free registration) finds that traditional asset managers are adding long/short funds to their line-ups at an astonishing rate.

The companies forecast that the amount of long/short assets managed by traditional money managers will increase by a whopping 75% to $345 billion by 2012.  Meanwhile the amount managed by actual long/short equity hedge fund managers will increase by only 25% to $580 billion.  (Those of you who contend that long-only managers have no business shorting may find this to be further evidence that 2012 will indeed herald the end of the world.)

Back in 2004, Agarwal, Boyson and Nail found that their 39 “hedged mutual funds” (Table 7 of their report) represented about 2% of all hedge funds.  BNY and Finadium find that today, there are 157 such funds managing $27 billion or about 4% of all hedge fund assets (see chart from report below): More…

(By: Steve Wallace, CAIA, Member – AllAboutAlpha.com Editorial Board) – Notwithstanding the recent out-performance of hedge funds, it’s been a tough year for High Net Worth Individuals (HNWI) and their even wealthier cousins, the Ultra High Net Worth Individuals (Ultra HNWI).  A recent Capgemini/Merrill Lynch report shows just how tough.  The “2009 World Wealth Report” showed, not surprisingly, that gains made during 2006 and 2007 were completed eroded primarily due to more aggressive asset allocations.

2013

However, that being said, it’s certainly not all doom and gloom.  The report forecasts that by 2013, HNWI financial wealth will total $48.5 trillion up from $32.8 trillion at the close of 2008 and well in excess of the $40.7 trillion at the end of 2007.  The figure below also illustrates the far higher forecast for the growth rate of wealth in Asia Pacific at a whopping 12.8% p.a from 2008 to 2013 (click to enlarge).

More Conservative Assets

Most of the people to whom I speak in my travels through Europe and the Middle East on behalf of the CAIA Association would probably agree that HNWIs significantly increased their exposure to more conservative assets during 2008, thus reducing their exposure to equities and alternative investments.

But as the figure below shows, HNWIs also increased their exposure to another alternative investment – real estate – as they saw new opportunities arise – mainly in residential real estate (click to enlarge). More…

Today, we bring you a couple of related tidbits we recently found buried deep within seemingly non-hedge fund research reports…

Private bankers, stung by Madoff, still see hedge funds as central to their business

It’s generally recognized that the Madoff Affair hit individual investors harder than it did institutional investors – and in doing so, precipitated an exodus of high net worth investors away from hedge funds in general.

But a survey by PWC published recently shows a different picture.  The firm’s 2009  Global Private Banking and Wealth Management Survey shows that private bank executives still see hedge funds and structured products as being central to their business in the next two years.

As the chart below shows, 70% of private banking heads say these investments are either “important” or “very important” parts of their business over the next 24 months. More…

The “Resistance”

Hedge funds may have been beaten into submission by the combination of market and regulatory events, but hedge fund strategies live on.  Morningstar’s Ben Alpert recently shone a spotlight on the tenacity of the alternative investment industry by referring to it as the “resistance” (to the traditional investing empire, one assumes).

Wrote Alpert:

“It’s true that the pace of new fund launches in the first quarter of 2009 was roughly half that of the past five years, causing a decline in the number of funds for the first time in memory…But even during the market’s darkest days of late 2008 and early 2009, new hedge funds were opening.  A search of Morningstar’s hedge fund database recently revealed nearly 100 inceptions in the fourth quarter of 2008 and 75.”

He goes on to describe several new mutual funds that use hedge fund strategies. More…

Despite the aversion retail investors have recently had to hedge funds, the hedgification of traditional investments is apparently continuing in some quarters of the money management business.

Back in March, Chip Roame, the founder and CEO of Tiburon Strategic Advisors told the online newsletter Advisor Perspectives that: More…

With many investors now convinced that markets will trade sideways for some time, they say beta returns should be forsaken in favour of alpha-centric returns.  Meanwhile, emboldened by what they see as a fire sale in equities, many other are increasing their equity beta exposure right now.  As a result, the age-old tug-o-war between active and passive management seems to have moved back to the front pages.

S&P released this report earlier in the week that was aimed squarely at those who believe active management embeds some kind of put option that protects it during market downturns.  The report highlights the common assumption that active managers can move to cash in times of distress – that they essentially trim their beta exposure in response to the prevailing winds (an argument often made by hedge funds – the quintessential active managers).

But despite this apparent advantage, S&P found that less than half of active managers outperformed their benchmarks in 2008 – a period when markets fell precipitously.  The report doesn’t mince words: More…