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1 September 2016 CFA Institute Journal Review

Skin in the Game versus Skimming the Game: Governance, Share Restrictions, and Insider Flows (Digest Summary)

  1. Marc L. Ross, CFA

Because hedge fund flows help predict returns, the authors argue that hedge fund managers have an incentive to use inside information on fund flows to trade ahead of clients. Using a proprietary database of changes in manager investments in their own funds, the authors show that manager investment decreases precede subsequent fund outflows and poor fund returns. This pattern is most pronounced in share-restricted, low-governance funds.

What’s Inside?

Fund flows into and out of hedge funds can help predict future fund returns. Because many funds have share restrictions that delay the release of information about fund flows, investment managers have an incentive to front-run investors. The authors show that manager outflows precede investor outflows over the following year.

How Is This Research Useful to Practitioners?

Share restrictions limit how quickly investors can withdraw their investment in a hedge fund. Although such restrictions offer benefits to both the manager and investor (i.e., to avoid forced selling), they create a situation of asymmetrical information that favors the manager because the manager knows about redemption requests before other investors. Such information asymmetry can become problematic when the fund manager both invests in his or her own fund and has the ability to trade ahead of other investors using such information.

Focusing on share-restricted hedge funds, the authors demonstrate that flows predict hedge fund performance. From 1998 to 2012, funds with recent inflows bested those with recent outflows by 4.5% annually. The authors observed no such performance spread for funds with low share restrictions. These observations seem to indicate that for managers who invest in their own funds, there is an incentive to trade ahead of clients to profit from inside information about fund flows. This incentive could be enhanced for funds that exhibit lower levels of governance and consequently have fewer shareholder protections.

Using a proprietary time-series dataset of managers’ investment in their own funds, the authors identify both significant fund flow patterns and returns that follow managerial investment changes. In particular, they observe that managerial investment reductions in funds with low governance are related to patterns of poor returns.

Those in the alternative investment space—along with performance measurement analysts, regulators, and policymakers—will find the authors’ analysis instructive and their conclusions sobering.

How Did the Authors Conduct This Research?

The authors’ research relates to literature on fund flows and corporate governance. Their work and conclusions focus on share-restricted funds and their interaction with corporate governance practices.

The authors draw on information from the Lipper/TASS database that includes information on returns, assets under management, and share restrictions (lockup and redemption-notice periods). Funds report monthly and are located in the United States. They eliminate observations with assets under management that are stale or indicate a value of zero. The examination period is from 1998 to 2012. The authors use conventional flow calculations to estimate fund flows, and redemption-notice periods and lockup periods proxy for shareholder restrictions.

First, the authors demonstrate the ability of fund flows to help predict returns. They sort hedge funds into groups by recent flows and show how fund flows predict fund returns. They demonstrate that the spread in returns between high-inflow funds and high-outflow funds (i.e., the flow-return spread) is significant for funds with longer share restrictions and also for funds in which managers have a higher ownership percentage.

The authors also construct a fund governance measure that is a function of such variables as audit, high-water mark, and SEC registration. They then show that the flow-return spread is larger among funds with lower governance levels.

Because flows predict returns, the authors offer evidence supporting their contention that hedge fund managers use inside information on fund flows to trade ahead of clients. They use a proprietary dataset containing a time series of managers’ own money invested in their funds from June 2007 to June 2011. Management investment changes and subsequent fund flows and returns are most pronounced in share-restricted, low-governance funds.

The findings hold in additional robustness tests that include cross-sectional regressions of share-restricted fund returns on prior month flows and governance. The authors do consider the possibility of return smoothing and whether investment style can explain degrees of flow-return spreads. Finally, they look at the effects of illiquidity, lockup, operational risk, and rounding errors in assets under management.

Abstractor’s Viewpoint

The authors shed important light on how governance and shareholder restrictions create incentives for managers to trade ahead of clients. They provide supportive evidence that such front-running actually occurs. Their observations should interest policymakers because poor governance practices, such as nondisclosure of managers’ investment in their own funds, can give the appearance of front-running. Additionally, the authors’ findings could imply that not only investment-level but also fund-level information, such as fund flows, could be deemed material inside information. Further research on the alignment of incentives for hedge fund managers could encompass non-US-domiciled firms to observe the extent to which governance practices are shared or different and why.

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