The Bias That Pays Off in the Hedge Fund Industry

Prime broker relationships in the secretive hedge fund industry are influencing the flow of money to managers — and it’s paying off for funds of hedge funds, according to new academic research.

Funds of funds overweight their investments in hedge funds serviced by “connected” prime brokerage firms, according to the paper this month by Arizona State University business professor George Aragon, Korea University Business School professor Ji-Woong Chung, and Byoung Uk Kang, a professor at Hong Kong Polytechnic University. This “bias is larger when the cost of hedge fund due diligence is higher relative to capital,” they said, and when firms housing funds of funds run a larger hedge fund business that could bring greater revenue to the prime brokerage firms.

Prime brokers are the investment banks and securities firms that provide services such as securities lending and global custody and clearing. The services give prime brokers “special insights about the trading activities of their hedge fund clients,” helping funds of funds in their search for hedge fund managers, authors said.

Prime brokers are seen as “information hubs,” providing a window into the “opaque and highly secretive hedge fund marketplace,” according to the paper. Connections to prime brokers “can arise when hedge funds managed under the same roof” as funds of funds subscribe to their services — even if the latter managers do not, the researchers said. 

Leaning on prime-broker connections for the selection of hedge fund managers has benefits. Bigger biases lead to “superior performance,” Aragon, Chung, and Kang said in their paper.

Prime-broker bias is larger among funds of funds with fewer resources to conduct due diligence, and when managers have “greater incentives to perform” for reasons such as personal capital investment, according to the authors.

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They found other areas of bigger bias among fund-of-fund managers.

For example, their bias is bigger for prime brokers serving a larger number of hedge fund clients but who are connected with a smaller number of other funds of funds, according to the paper. The bias is also larger among funds of funds run by management firms with larger and more established hedge fund businesses. 

That’s because prime brokers having a greater incentive to share information with funds of funds when they see an “opportunity to exchange information for higher prime brokerage revenues,” the researchers said.