New Developments in Long-Term Asset Management
Monika Piazzesi and Luis Viceira, Organizers
Third Annual Conference
New York, New York
May 3-4, 2018
Skin or Skim? Inside Investment and Hedge Fund Performance
Delegated asset managers are commonly thought of as being compensated only through fees imposed on outside investors. However, access to profitable, but limited, internal investment opportunities can also be a form of compensation for managers. Consider the hedge fund industry, which manages over $3 trillion in assets, of which $400 billion can be attributed to investments from insiders and related parties. Return to this insider capital is an important, but previously overlooked, component of hedge fund compensation and a potential conflict of interest between managers and investors.
Other Conference Papers
The Endowment Model and Modern Portfolio Theory, Stephen G. Dimmock, Nanyang
Neng Wang, and Jinqiang Yang
Arpit Gupta and Kunal Sachdeva outline a framework in which managers face capacity constraints in their funds, choose to endogenously create new funds with different strategies, and can allocate internal capital across various funds under their control. When managers have more personal capital committed, they internalize the fact that raising additional capital is dilutive to existing investors in the sense that it causes the strategy to operate closer to its capacity constraint, lowering the returns for all existing investors. A key prediction from their model is that higher inside investment better aligns incentives between managers and investors and induces managers to limit the size of their fund, resulting in higher alphas even in equilibrium.
The researchers document the extent of inside investment in fund families across the universe of hedge funds using novel regulatory data from the SEC's Form ADV. They find that inside investment – as measured either by percentage or gross investment – remains a predictor of excess returns even when comparing different funds within firms. An investor moving to another fund in the family with a standard deviation rise in inside investment would see a rise in excess return of 1.26 percent annually. This indicates that inside investment is an important, and previously neglected, cross-sectional predictor of hedge fund returns.