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Side-by-side surprise

A pair of recent academic studies highlight the performance implications for money managers that offer hedge funds and mutual funds.

A growing cadre of mutual fund firms have launched in-house hedge funds to capture higher fee revenue and better compensate their top managers. Critics contend that this practice -- known as side-by-side management -- creates conflicts of interest that can harm the firm's mutual fund investors. But regulators aren't sure. "It is not black and white," says Robert Plaze, associate director of the Securities and Exchange Commission's Division of Investment Management. Taken together, two recent, and seemingly contradictory, studies suggest a possible answer: Running hedge funds can hurt a firm's mutual fund performance, but not if the same person or team manages both funds. In that arrangement, though, hedge fund investors will tend to suffer.

The first paper, published in June, struck a blow against side-by-side management. Scott Gibson of the College of William & Mary's Mason School of Business and Gjergji Cici and Rabih Moussawi of the University of Pennsylvania's Wharton School of Business studied the returns of 457 mutual funds run by 71 firms engaged in side-by-side relationships, from an individual running both a mutual fund and a hedge fund to separate teams overseeing the funds. The researchers found that these firms' mutual funds underperformed those of firms not running hedge funds by an annualized 124 basis points from 1994 to 2004. Gibson and his colleagues also discovered that the firms they studied allocated more underpriced initial public offerings to their hedge funds.

In November another trio of researchers reached a different conclusion. Loyola University's Tom Nohel, the University of Illinois's Z. Jay Wang and Lu Zheng of the Paul Merage School of Business at the University of California, Irvine, limited their study to 112 managers or teams that personally oversaw a mutual fund and a hedge fund. They found that the 304 mutual funds run by these managers outperformed comparable funds that operated without side-by-side relationships by 1.5 percentage points a year from 1990 to 2005. During that time, the funds returned an extra $2.05 billion annually to their investors. "Side-by-side managers routinely outperform their peers," the authors conclude.

Why the discrepancy? One possibility, Nohel reckons, is the role of personal reputational risk. The potential conflicts of interest are arguably more acute when the same portfolio manager or team is running both a hedge fund and a mutual fund; that manager could easily be tempted to save his best trading ideas for the vehicle that pays a 20 percent performance fee. But with the SEC warning firms to step up procedures to prevent such favoritism, managers in side-by-side arrangements have a strong incentive to avoid regulatory blunders. They must also work to protect their standing. "With a mutual fund they have a public track record," Nohel surmises. "They don't want to jeopardize that."

For a hedge fund investor, that can be a costly burden. Nohel and his colleagues also studied 156 side-by-side managed hedge funds and found that they had lower returns than hedge funds whose managers did not simultaneously manage a mutual fund. Hedge fund returns in the first group were more dependent on the overall direction of the markets they traded in, suggesting they had significantly fewer short positions than the latter group.

The professors also tested the returns of 37 individual managers who started out with a hedge fund and later added a mutual fund. After the change the managers' hedge fund returns fell on average by 11.2 basis points per month versus the universe of comparable funds. It seems that running a mutual fund can be a distraction, even for a hedge fund pro.