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The grass is always greener… mutual fund managers’ walk on the wild side not so wild after all.

wildside [1]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 [2] 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.

On a broader level, the industry’s unbridled growth indeed attracted many to jump ship: According to aggregated from the 2009 Investment Company Fact Book for statistics on mutual funds [3] based on data from Hedge Fund Research [4], assets under management (AUM) in mutual funds grew some 167% from $4.5 trillion in 1997 to about $12 trillion in 2007, while AUM of hedge funds grew from $500 billion in to about $2 trillion in 2007 – growth of 300%.

Over the same period number of mutual funds grew from about 6,700 to 8,000, whereas the number of hedge funds grew from about 3,000 to 10,000.

Yet a study published last month called, The good, the bad or the expensive? Which mutual fund managers join hedge funds?’ [5] notes that while potential opportunity and returns certainly lured many to leave the world of MERs for the world of 2s and 20s, the reality was that the compensation wasn’t as easy to come by as it seemed.

Comparison [6]

Table 4. Career Moves of Mutual Fund Managers

Authors Prachi Deuskar, Joshua M. Pollet, Z. Jay Wang and Lu Zheng found that mutual fund managers who were provided a platform to also manage hedge fund strategies on a “side-by-side” basis typically stayed put with their mutual fund manager hats on, while those that were kept shackled to their mutual fund portfolio management chairs “severed all ties” to either start their own hedge fund or join one.

As the table from the report shown below illustrates, the sample used consisted of 287 mutual fund managers that joined hedge funds during the period from 1993 to 2006. Of those managers, 157 retained their job in the mutual fund industry, which the authors labeled Side-by-Side Managers, because they simultaneously managed both mutual funds and hedge funds. The remaining 130 managers severed all ties with the mutual fund industry to join hedge funds. That group the authors labeled Complete Switchers.

Annual patterns of switchers [7]

Table 1. Annual Pattern of Switchers

The authors further noted that those managers who high-tailed it out of the mutual fund industry on average took over substantially lower AUM. This lower AUM base in turn meant that on average making up for the loss of a management fee by earning incentive fees was virtually impossible.

For example, to account for a $311 million decline in AUM by switching to a hedge fund from a mutual fund, a manager charging a typical 20% incentive fee would have to earn a profit of $15.55 million (3.11/20%). To earn that, the manager would have to rack up an annual rate of return of, wait for it, 172%, “…an implausibly high rate of return even allowing for leverage, ” according to the report’s findings.

AUM SWitchers [8]

Table 2. Descriptive Statistics

So why would a hedge fund hire an inferior-performing Complete Switcher? Passive versus active: passive mutual fund index investing versus active hedge fund strategy investing – and the results that be accomplished when the horse is let out of the stable.

And why would a Complete Switcher make the leap to the hedge fund world? Poor performance, as noted, and the promise of ding better in a perceived less constrained environment, but also the ability to take on more risk – and in turn potentially earn that 172% annual return.

Of course, things have changed a lot since 2006, and the world changed in 2008. Perhaps with everybody on a new lower plane the opportunity for career advancement for mutual fund managers is still there. On the flip side, sticking to passive indexing doesn’t seem so bad going into 2010.

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