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Side-by-Side Management may favor Hedge over Mutual Funds

Hedge over Mutaul Funds:

A new study that analyzes the performance of institutional investment advisors who manage hedge funds "side by side" with mutual funds say about a diverse, more complicated story. The researchers found that the structural divergences between fees and ownership often origin side-by-side managers to make portfolio decisions that favor hedge fund investors at the expense of mutual fund investors, with expense being the key word.

The hedge fund industry has seen considerable growth over time as high-net worth individuals have flocked to this investment category. Its attractive configuration and compensation have also attracted some of the best money managers in the world, often at the expenditure of the mutual fund market. To help reduce the impact of this shift, institutional investment advisory firms have argued that for mutual funds to preserve talent they should be managed by people also running hedge funds.

Hedge over Mutaul Funds:Empirical Evidence

The study is about: For Better or Worse? Mutual Funds in Side-by-Side Relationships with Hedge Funds, (2006), realized that "conflicts of interest motivate side-by-side managers to intentionally transfer performance from mutual funds to hedge funds." The study was conducted by three academic researchers, Gjergji Cici, Scott Gibson and Rabih Moussawi, from the Wharton School (University of Pennsylvania) and from the College of William and Mary. It has been observed that the performance of 71 advisory firms who managed 457 equity mutual funds. These funds were run side by side with hedge funds for at slightest some period of time between 1994 and 2004. For organize purposes, the researchers also chose a group of funds that were the same in major respects, except that these funds were not associated with a hedge fund at any time.

The study makes several key points that investors should know about :

Fund managers receive privileged compensation (relative to mutual fund managers) when hedge funds perform sound. Mutual funds that are unaffiliated with hedge funds usually perform superior than mutual funds that are in side-by-side relationships with hedge funds. Side-by-side mutual funds usually received an appreciably lower portion of low-priced shares of initial public offerings (IPOs). According to the study, the 457 aggressively managed funds underperformed the comparable unaffiliated funds by 1.2% per year, in place of an estimated loss of some $5.6 billion in potential returns during 2004.

Until the new study was published, there was no definite evidence about whether these side-by-side arrangements created conflicts of interest in which mutual fund investors were disadvantaged comparative to investors in hedge funds. According to the co-authors, the study supports concerns uttered by regulators about potential conflicts of interest caused by these side-by-side arrangements. "We find well-built empirical evidence that regulators' concerns about managerial conflicts of interest are reasonable. Side-by-side funds demonstrate return gaps that underperform those of matched funds by cost-effectively and statistically significant margins," the study reads. Remember that this is not a good guys’ vs. bad guys’ situation. Hedge funds have, and likely will, prolong to have a significant role in the world's securities markets. In accordance to a May 2006 Securities and Exchange Commission (SEC) report, even though hedge funds represent just 5% of all U.S. assets under management, they account for about 30% of all U.S. equity trading volume.

Regulatory Concerns

To the 1940 act, hedge funds are not subject. In addition, since hedge funds issue securities as "private offerings", they are neither obligatory to be registered with the SEC under the Securities Act of 1933, nor do they have to make periodic reports according to the Securities Exchange Act of 1934. The main confession document for hedge funds is called the offering memorandum, which is not required to be as wide-ranging as a mutual fund's prospectus or other required offering documents.

Mutual fund shares are public offerings that must be registered with the SEC under the 1933 act, and fund companies are required to make periodic reports to shareholders as required by the 1934 act. Hedge funds are under no such obligation.

These differentiations in regulation prompted the SEC to learn the operation and practices of hedge funds. The SEC's 2003 report Implications of the Growth of Hedge Funds highlighted a number of areas of alarm. The report significantly mentions the side-by-side management of client accounts in hedge funds and mutual funds, and says that "conflicts of interest between investment advisors and their clients are not latest. Unique information, yet, including the nature of the fees paid, the interests of the advisor and the nature of hedge fund strategies themselves bring[s] these conflicts into still sharper focus."

In December 2004, the SEC adopted rules that mandatory most hedge funds with assets greater than $25 million to register under the Investment Advisors Act of 1940 except the hedge fund required investors to "lock up" their investments in the fund for two years. The rules came into existence on February 10, 2005, and advisors were required to register under the rule had to do so by February 1, 2006.

Problem Solved?

The road to creating a hedge fund regulatory structure is barren, at least for the present. On June 23, 2006, the U.S. Court of Appeals for the District of Columbia Circuit throw out the proposed hedge fund registration rule, which means that the legislative procedure has to make a fresh start again.

A succeeding hedge fund regulation bill was introduced in the U.S. House of Representatives by Massachusetts Representative Barney Frank a short period later. Though, in view of SEC Chairman Christopher Cox's decision not to appeal the district court's decision, it appears that the process of developing hedge fund regulations will have to start all over again.

What Investors Can Do

Almost 15% (or 379) hedge fund advisors that registered with the SEC reported that they also manage at least one mutual fund, assuring that the potential for conflict of interest will continue to be a distress for regulators and investors.

Investors will need to think badly about whether or not it makes sense to put their money in mutual funds that are managed side by side with hedge funds. A straightforward alternative is to avoid investment advisory firms that have such arrangements in total.

Nevertheless, investors who are taking into account going with a firm that manages these funds side by side should do to their groundwork. First of all investors required to take an honest look at such important factors as your age, income, cash flow needs, tax status, investment objectives, risk tolerance, general financial situation and needs.

Cautiously evaluate the financial incentives under which the advisory firm or investment manager operates (for example, performance and other fees). If these are not well-matched with your investment goals and objectives, move on. There is abundance of firms out there that will do right by their customers. It is well importance the legwork essential to find them.

Financial media and other organizations that report on investment topics habitually refer to hedge funds as carelessly regulated or largely unregulated. This is true in particular when compared with mutual funds (open-end and closed-end investment companies), which are regulated very closely, chiefly under the Investment Company Act of 1940.

Mutual Funds
Mutual Funds