NYU and Columbia University found that funds where the Hedge Fund Manager had skin in the game outperform but tend to keep small funds. These funds not only earn more but are less sensitive to performance driven flows.
You can read that paper here.
The research was carried out using HFR, EurekaHedge, eVestment and CISDM. Authors of the paper Arpit Gupta and Kunal Sachdeva, looked at the characteristics of investors and the performance of 720 Hedge Funds.
They found that funds with no outside capital earned 4.3% higher excess returns annually compared to funds with only outside investment. Additionally, they found that these funds were comparatively small and outperformed on a risk adjusted basis. Just one-standard-deviation increase in investment resulted in 1.4% to 1.7% in excess returns annually.
Gupta and Sachdeva believe one possible reason could be, Hedge Fund Managers prioritise those funds that contain more of their personal investments, putting those funds under the control of their best portfolio managers.
Alternatively, they believe that inside investors are better informed about managerial ability within the fund family. Therefore, they allocate their capital to the better fund managers.
In short both researchers believed that having managers and investors better aligned over incentives could only generate positive results.
The data also found that these firms deliberately remained as smaller funds even when the opportunity to attain more assets was on the table.
When more than 20% of funds were owned by insiders, managers did not raise more capital even after periods of positive excess performance. Intriguingly they continued to outperform for longer than funds that did see additional inflows.
This cap being put on outside investment is motivated by Hedge Fund Managers having their own money on the line as they desire better performance and high returns.
Gupta and Sachdeva surmised that Funds which rely more on insider money outperform funds which do not eat their own cooking.
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