(James Saft is a Reuters columnist. The opinions expressed are his own)
Aug 17 (Reuters) - Combine the standard hedge fund compensation model with the reality of declining fund performance as assets under management increase and you have a whopping conflict of interest.
Unlike mutual funds, hedge funds typically get an incentive fee, usually 20 percent of profits, in addition to a 1 or 2 percent annual management fee.
That's meant to align the interests of the investor and manager, but flaws in the contract design leave clients open to managers prioritizing their own financial interest.
A newly published study demonstrates that when it comes to hedge fund size the sweet spot for manager compensation is considerably higher than the sweet spot for shareholder returns.
"My empirical results indicate that the optimal size for managers' compensation differs substantially from the optimal size for fund performance. In other words, the standard compensation contract does not solve the conflict of interest between fund investors and fund managers in the hedge fund industry," Chengdong Yin of Purdue University writes in the Journal of Finance. (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2126689)
At the heart of the issue are diseconomies of scale, an ugly term which simply describes situations in which a given arrangement of resources gets less efficient the larger it grows. For hedge and mutual funds diseconomies of scale have been much studied and argued about, but there is broad agreement that it is harder to run a very large fund in a given strategy, and that these very large funds have a tendency towards underperformance. It can be harder finding good opportunities when you are large, much less getting meaningful exposure to them without driving the price up.
In mutual funds, diseconomies of scale and the potential conflicts of interest are, up to a point, self correcting. As fund flows follow fund performance, the biggest funds, if they lag, will lose assets, driving managers' pay down alongside.
For hedge funds though, the math is considerably different.
To examine the issue, the study looked at results from over 2,000 hedge funds of varying strategies from 1994 through 2009.
You Scratch My Back and I Will Too
The study divided funds into five groups by size and tracked their lagged returns using a style-adjusted measure meant to allow comparisons between, for example, a long-short fund and one with a global macro approach. The fourth-largest quintile was the top performing, with style-adjusted outperformance of 0.26 percentage point for a group with an average of $155 million under management. Step up to the largest quintile and assets under management jump to $780 million but performance falls to -0.30 percentage point, according to the study.
If standard hedge fund contracts were aligning interests properly, you would expect the largest funds, which after all performed less well, to be less well paid too.
That, unsurprisingly, was not the case. While the second-largest quintile, the best performing, made on average $7.77 million in compensation, the largest took in $32.77 million.
So we have at the large end of hedge funds a diseconomy of scale but one which is profitable for managers. The study offers two possible explanations. First, that the increase in fund assets is faster than the decrease in performance, which cuts down on the performance-based fee. Or, second, that the management fee becomes more important, in absolute dollar terms, the bigger the fund gets.
As fund managers are motivated by their absolute dollar take-home pay they "likely have strong incentives to increase their assets under management," according to the study.
Hedge fund firms also have perverse incentives to increase the number of funds they sponsor. Adding individual funds might seem to be a workaround of the issue of declining performance above as individual funds rise in size, thus allowing the firm to grow revenues. Yet fund firm level data shows that the entire fund family can suffer in performance if the firms manage too many funds.
Hedge fund investors, the data shows, chase performance, but are differently sensitive to different levels of relative returns. They fire the poorest performers and plunge into the best, but are least likely to react one way or another when performance is in the middle. Since getting too big means underperforming, and losing assets, hedge funds will tend to be more likely to close their funds to new investors around the fund size at which they can make style-average returns.
Investors might want to take steps to study the optimal size for the particular strategy they want to invest in via a hedge fund and make it a policy to trim their exposure over that level. (Editing by James Dalgleish)