Wednesday, July 22, 2009

Not-so-stealth trading

What happens when the same management groups runs two very different funds, one targeted to more sophisticated investors and the other to suckers ... um, retail customers?

What happens, to be more concise, if one group runs both a hedge fund and a mutual fund?

For many years there has been a widespread assumption that the danger in uch arrangements is this: the hedge fund will frontrun the mutual fund, taking advantage of its opportunties.

In 1993, Michael Barclay and Jerold Warner set out this theory in respectable academic form in an article in the JOURNAL OF FINANCIAL ECONOMICS. The gist of their hypothesis was that when these "concurrent managers" became aware of a really good profitable opportuntiy, they would trade in it first for the hedge fund account, because after all the fees they take from a hedge fund are very high and tied to profits. The mutual fund and its investors would get at best the left-overs from these opportunities.

Recent research, though, indicates the opposite is the case. Concurrent management is more likely to be biased AGAINST the hedge fund than in its favor. The empirical data is summarized in an article in the August 2009 issue of the Journal of Banking & Finance. How could this happen? Why bias your activity against the source of the larger set of fees?

The authors of that paper, Li-wen Chen and Fan Chen, hypothesize that concurrent management is often an effort to use in the hedge fund domain the "reputational capital" developed in the mutual fund domain. The mutual fund results are by far the more transparent, the more widely available, in any such case, so they work as advertising for both of the funds.

At the margin, then, the concurrent managers favor their mutual fund.

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