Hedge fund managers with prestigious degrees aren’t necessarily smarter than their peers. But they do use their networks and the reputations of their alma maters to better structure their funds and deliver higher returns, according to new research published in the fall Journal of Alternative Investments.
The study, called “Manager Characteristics and Hedge Fund Returns, Liquidity, and Survival,” found that the educational pedigrees of hedge fund managers directly affected arcane, but crucial, characteristics like the liquidity of their portfolios.
“When I read the papers analyzing the impact of hedge fund education on performance, I thought something is missing,” Hyuna Park, the paper’s author and an associate professor at Brooklyn College of the City University of New York, said in an interview with II. “Now I’ve found that funds that have managers who are highly educated invest in more illiquid assets, as well as impose more severe restrictions. That is a very strong relationship.”
According to the study, these funds not only delivered higher returns on average, but also lower risk, higher Sharpe ratios, and higher alphas, or returns above a benchmark.
Investors often view limitations on redemptions negatively, but these restrictions give managers the ability to put more money to work in investments that are less liquid. Less liquidity means assets are more difficult to buy and sell, but it also means a higher payoff potential. Hedge fund managers with more investor limits in place can also wait out downturns, reducing the risk that they have to sell positions at lower prices.
In the paper, Park argued that alumni networks contribute to the bump that managers get from top schools. “The major driving force is trust inspired by the reputation and network of elite institutions,” she wrote in the study. She defined elite education as a school in the top 10 of U.S. News’ ranking of universities and business schools. The study looked at hedge fund data between 1994 and 2015.
[II Deep Dive: Want To Access the Best Private Equity Managers? Be Elite]
Park found that a manager’s education signaled whether or not their hedge fund would be around in the long term. But an even better indication of survival, according to the study, was whether or not a manager that holds the Chartered Financial Analyst (CFA) designation. Between 1994 and 2015, the so-called hazard rate, or rate at which they fail, of funds managed by CFAs was 13.6 percent lower than other funds after controlling for factors such as risk, return, and investment style, according to the paper.
Other researchers have studied the connection between lockup provisions and better performance as well as the effect of having attended a prestigious school, but this is the first time that research has addressed why some funds can impose stronger share restrictions than others.
Park found that on average managers with a degree from a top 10 school ran funds with longer lock-up and redemption notice periods. These asset managers also processed requests from investors to redeem their shares less frequently than other funds. In addition, managers with elite degrees charged higher performance fees, but lower annual management fees than other funds.
“These findings are especially important for hedge fund investors who have long investment horizons, such as pension funds,” Park wrote in the paper. “This article shows that the educational backgrounds and certification of hedge fund managers are related not only to the liquidity premium that long-horizon investors can earn, but also to lower search costs due to high survival rates.”
The research has already attracted some criticism, according to Park. She told II that she had just received an email from a fund manager complaining that the study perpetuated biases about educational backgrounds.
“His point is that papers like mine can be used by HR people or funds to discriminate against managers who don’t have an Ivy League education,” she said. “I never intended to have my paper used for that purpose. I’m not the first to find the relationship. But I wanted to dig deeper and investigate the reasons behind it. I’ve shown that the difference is not about knowledge. It’s about the network effect. At least, my research is ‘helping to demystify the difference.’”