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SAFT ON WEALTH-In hedge funds, skin in the game is critical: James Saft

(James Saft is a Reuters columnist. The opinions expressed are his own)

July 19 (Reuters) - You might want to make sure your hedge fund managers have lots of skin in the particular game you are playing alongside them.

You might also want to make sure they dont grow a fund too large.

Those are among the implications of a new study which finds insider investment in hedge funds is a good predictor of returns. (https://papers.ssrn.com/sol3/papers.cfm?abstracttid=2982889)

Hedge funds have long touted their willingness to invest alongside their clients, with some $400 billion of the $3 trillion hedge fund universe belonging to insiders and related parties. That means co-investment potentially rivals fee and profit-sharing income as a source of hedge fund manager compensation, and, in theory, motivation.

Using Securities and Exchange Commission data on insider ownership of hedge funds from 2011-2016, the study finds a meaningful impact on how those funds perform.

We find that funds with greater investment by insiders outperform funds with less 'skin in the game' on a factor-adjusted basis; exhibit greater return persistence; and feature lower fund flow-performance sensitivities, Arpit Gupta of New York University and Kunal Sachdeva of Columbia University write in the study, released in June.

These results suggest that managers earn outsize rents by operating trading strategies further from their capacity constraints when managing their own money.

In other words, not only do they produce better results when their own money is a larger percentage of their fund, hedge managers arrange things so that their money is at work in funds facing fewer size limits on profitable strategy implementation.

The outperformance tipped by insider investment is not small. A fund owned 100 percent by insiders sees a rise in excess returns, or outperformance, of 4.3 percentage points a year compared to one in which insiders have no exposure. Given that, in 2013, for example, BlackRock calculates that the hedge fund universe median alpha was 3.1 percentage points, the extra rewards reaped by insiders is comparatively, and absolutely, huge.

At first blush, the simple implication would be to invest where hedge fund insiders themselves are putting their money, but matters are a bit more complicated. For one thing, the results may not be solely driven by managers acting in their own best interest. Other firm insiders may have better information about manager skill and be putting their money to work with those best positioned to outperform.

CAPACITY PROBLEMS

The study showed that returns didnt follow the expected pattern; a fund outperforms, attracts large inflows and then sees its performance degrade. Most funds do this, but those with 20 percent or more insider allocations seemingly defy the laws of capacity gravity.

For this subset of funds, high returns do not lead to excess inflows; instead excess returns are persistent. The joint behavior between fund flows, performance, and inside investment suggests that capacity constraints are an important driver of hedge fund performance; and that managers of hedge funds choose to deploy less capital (and so gain greater alpha) when their own personal capital is involved, the authors wrote.

Size does matter in fund management, as illustrated by a recent study which found mutual fund outperformance falling by 20 basis points over a year in which the size of the fund doubled. (https://papers.ssrn.com/sol3/papers.cfm?abstracttid=2990737)

Thats likely because funds suffer in a variety of ways as they grow. Not only might a manager run dry of ideas, but her existing ones usually face capacity constraints. It is a lot easier to find something interesting to do with $200 million than $5 billion, and when you put the larger sum to work the market will tend to move against you as you invest.

Managers, it may be, are acutely aware of these capacity constraints and put their own money to work accordingly, perhaps co-investing in the larger and still profitable to manage funds, but shading their own holdings towards funds which, for whatever reason, have more room to maneuver.

The hedge fund study also found evidence suggestive of the idea that managers use new fund creation and allocation of their private capital to skim investors. Firm performance gets better when a new fund has mostly outsider capital but insider capital remains in existing funds, as opposed to when it shifts to the new funds.

Clearly, investors should become, and perhaps are becoming, more sensitive to how their investments in a hedge fund will be affected by its capacity constraints.

A combination of insisting on a high level of co-investment by insiders and rules which cap how quickly a fund can grow, or be replicated by a new fund, seems to make sense. (Editing by James Dalgleish) )