Hedge fund managers with skin in the game really do yield the best results, according to research from NYU and Columbia University.
When managers invest in their own hedge funds, the funds earn more and are less sensitive to performance-driven flows, said Arpit Gupta, an assistant professor at NYUs Stern School of Business, and Kunal Sachdeva, a PhD candidate at Columbia Business School, in a paper this month.
Greater insider investment better aligns incentives between managers and investors and induces managers to limit the size of their fund, resulting in higher alphas, they said. When funds rely on outside capital, managers are compensated primarily from managerial fees and leave little value to outside investors.
Raising more capital lowers returns for existing investors a fact that the researchers said managers internalize when they are investing their own money. As a result, funds with higher levels of inside capital are comparatively small and outperform on a risk-adjusted basis, according to Gupta and Sachdeva.
In examining data from research providers such as HFR, eVestment, EurekaHedge, and CISDM, as well as regulatory filings, the authors found that funds with no outside capital earned 4.3 percent higher excess returns annually compared to funds with only outside investments.
When more than 20 percent of funds were owned by insiders, managers did not raise more capital even after periods of positive excess performance and continued to outperform longer than funds that did see additional inflows.
By limiting fund inflows in periods in which funds experience high returns, insider funds are able to maintain persistently high excess returns over time, the authors wrote. In doing so, funds are foregoing management fees on additional capital in lieu of greater excess returns on privately invested capital.
In other words, their compensation stems from performance rather than fees tied to the amount of assets managed, better aligning incentives of managers and outside investors, according to the paper.
Funds which rely more on insider money outperform funds which do not eat their own cooking, Gupta and Sachdeva said.