The following is a study by Narayan Naik, Director, Centre for Hedge Fund Research and Education, London Business School, together with Vikas Agarwal and Naveen D. Daniel from Georgia State University.
Interestingly, investors in mutual funds and hedge funds deal with these two problems very differently. To address the problem of conflict of interests, hedge fund investors pay performance-linked incentive fees and require co-investment by the manager, while mutual fund investors typically pay a fixed fee and do not ask managers to invest in their funds.
To mitigate the problem of abuse of managerial latitude, mutual fund investors use regulation, disclosure, and imposition of risk limits. In extreme circumstances, investors even take legal action against their managers as we saw in the case of the Unilever pension fund versus Merrill Lynch Investment Managers.
In contrast, hedge fund investors recognize the beneficial effects of managerial discretion and accept impediments to capital withdrawal to provide the manager with greater investment flexibility. These different approaches have important implications for fund performance and money flows from investors.
There exist interesting similarities in the way shareholders in corporations and investors in hedge funds address these agency problems. For managerial incentives, similar to hedge fund investors paying performance-linked incentive fee to their managers, shareholders in corporate firms award their top executives stock options as part of their compensation. For managerial flexibility, analogous to hedge fund investors locking in their capital during the lockup period after which they are free to divest, shareholders in corporations grant their board of directors a fixed term in office after which they need to be re-elected. These similarities suggest that there may be lessons that shareholders in corporations and investors in hedge funds can learn from each other's experience.
Although our delta measure takes into account hurdle rate and high-water mark provisions, the very presence of these provisions may have a direct impact on performance. For example, Lambert and Larcker (2004) show that the optimal contract for managers is frequently one that involves out-of-the-money options.Since hurdle rate and high-water mark provisions effectively make the call option out-of-the-money, arguably such features should motivate the managers to deliver superior performance. Therefore, we also included hurdle rate and high-water mark provisions as our other two proxies for managerial incentives. One expects funds with greater managerial incentives to perform better and to attract greater money flows.
Next, we proxied managerial flexibility by the extent of impediments to capital withdrawals, namely, lockup, notice, and redemption periods, specified in the contract. Arguably, higher impediments to withdrawals provide the manager with greater freedom to follow different investment strategies. Therefore, one expects funds with greater managerial flexibility to display better performance. Although investors prefer better performance, all else equal, in order to meet unanticipated liquidity needs, one expects hedge fund investors to place more money into funds with lower lock-up, notice, and redemption periods.
Finally, we believe that a useful proxy for managerial ability would be the performance record (returns and persistence in returns) of a fund. Due to limited disclosure, hedge fund investors have restricted access to information on portfolio holdings. Furthermore, due to the dynamic nature of hedge fund trading strategies, periodic information on holdings may be of limited use. Therefore, investors may be forced to rely on past performance and persistence in performance to infer managerial ability. In such a case, one would expect funds with better past performance to attract larger money flows.
Using a union of four large hedge fund databases (CISDM, HFR, MSCI, and TASS) we investigated how managerial incentives and flexibility related to the performance of and money flows in the hedge fund industry. We found that hedge funds with greater managerial incentives are associated with better performance (higher returns, more likely to be persistent winners, and less likely to be persistent losers).
Investors seem to recognize the benefits of managerial incentives such as performance-linked incentives fees as these funds are rewarded with higher money inflows.
Funds with greater managerial flexibility also generate higher returns and are more likely to be persistent winners and less likely to be persistent losers. However, investors dislike restrictions such as longer lockup periods since they cannot liquidate their investment as and when they need the money. Accordingly, we found that money flows were lower for funds with greater managerial flexibility. The study also showed that investors directed more money into funds with superior past performance, as this can be seen as a proxy for managerial ability. In such a case, one would expect funds with better past performance to attract larger money flows.
These results are important in shedding light on the efficacy of the contractual arrangements in the hedge fund industry. They also have significant implications for investors and managers – the results can help investors in improving the capital allocation process and fund managers in increasing their enterprise value. Given the recent trend of retail investors investing in hedge funds, we suggest that these results will also be of interest to regulators.
Our investigation has uncovered many results that are new to hedge fund managers. First, it shows that funds with better managerial incentives and greater managerial flexibility are associated with higher returns. Also, such funds are more likely to exhibit persistently good (above-median) returns and are less likely to exhibit persistently poor (below median) returns. It documents that funds with better managerial incentives experience more money flows while funds with higher managerial flexibility (i.e. greater impediments to withdrawals) attract less money flows; funds with better managerial ability will generally attract higher money flows. Overall, these findings have served to significantly improve our understanding of the determinants of performance and money flows in the hedge fund industry.
The findings contribute to several areas of finance: our findings of managerial incentives being positively related to performance has interesting implications for the corporate finance literature. Our proxies for incentives do not suffer from potential endogeneity problems, and thus provide a cleaner test of the relation between managerial incentives and performance.
Second, our findings regarding the effects of incentive-linked compensation have interesting implications for the mutual fund industry. Elton, Gruber and Blake (2003) have already studied the performance of mutual funds charging symmetric fulcrum-type incentive fees. This design of incentive fee contract differs from that in hedgefunds that have an asymmetric call-option-like incentive fee contract. Our findings enable the comparison of the performance implications of offering symmetric versus asymmetric incentive fee contracts.
In addition, the discovery that funds with high-water mark provisions have higher returns has interesting implications for executive compensation literature. Despite Lambert and Larcker's prediction that the optimal contract for corporate managers is frequently one that involves out-of-the-money options, it is difficult to test that prediction in corporations, since most firms (95% according to Murphy, 1999) award at-the-money options to their top executives. Given the imposition of hurdle rate and high-water mark results in grant of out-of-money options to hedge fund managers however, our findings do provide empirical support to Lambert & Larcker's predictions. They also suggest that more research is required concerning performance implications of granting out-of-the-money options to top executives.
Our discovery that higher managerial flexibility is associated with better performance has additional implications for agency theoretic literature. Although agency theory predicts a negative relation between managerial latitude and performance, empirical evidence in the corporate finance literature has been mixed.1 Arguably, self-serving incentives created by managerial latitude would be restrained in hedge funds, since managers are co-investors and face strong financial incentives. Thus, our finding suggests that it may be possible to counter negative effects of managerial latitude through appropriate financial contractual arrangements.
Finally, given the similarities between hedge fund managers' contracts and those of the top executives of corporations, the findings also have wider implications in the field of executive compensation.
A full copy of this report is available from the London Business School (+44 207 262 5050) www.london.edu
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1 Several studies have examined the relation between managerial discretion and performance. Berger at al (1997) and Denis et al (1997) find a negative relation, Demsetz and Lehn (1985) and Agrawal and Knoeber (1996) find no relation, while Kesner (1987) and Donaldson and Davis (1991) find a positive relation between managerial discretion and performance.