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For Better or Worse? Mutual Funds in

Side-by-Side Management Relationships with Hedge Funds

We are grateful to Gordon Alexander, Vladimir Atanasov, Roger Edelen, Pedro Matos, John

Merrick, John Rea, Jonathan Reuter, Erik Sirri, Sheridan Titman, Lori Walsh, and participants at

the Frank Batten Young Scholars Conference 2006 and Western Finance Association 2006 for

Abstract

Firms that engage in the simultaneous, or “side-by-side”, management of mutual funds and hedge

funds have a fiduciary duty to each fund’s investors to make portfolio decisions and to execute

such favoritism. The reported returns of side-by-side mutual funds are significantly less than

those of similar mutual funds run by firms that do not also manage hedge funds. A

decomposition of reported returns into holdings-return and return-gap components and return-

persistence tests also suggest favoritism. Finally, examining a potential wealth transference

mechanism, we find evidence consistent with side-by-side mutual funds getting less of a

contribution to performance from IPO underpricing than matched unaffiliated mutual funds.

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Delegated portfolio management firms that run multiple funds have a fiduciary duty to

each fund’s investors to make portfolio decisions and to execute trades in the most favorable way.

This fiduciary duty is put to the test, however, when management firms can increase fee income

by treating fund investors inequitably. Consistent with the implementation of such strategies,

Gasper, Massa, and Matos (2006) provide evidence suggesting that mutual fund families sought

to increase fee income by strategically transferring performance across member funds.

Specifically, strategies favored high-fee funds or younger-aged and high-performing funds best

positioned to take advantage of the convex flow-return relation.1 Of course, this increased

performance came at the expense of other mutual fund investors.

In this paper, we examine another setting where delegated portfolio management firms

have incentives to strategically transfer performance across the funds they oversee. We examine

firms that engage in the simultaneous, or “side-by-side”, management of mutual funds and hedge

funds. Given the structural differences in fees between mutual funds and hedge funds, one might

expect management firms’ incentives to transfer performance from mutual funds to hedge funds

to be at least as great as across mutual fund family members. In contrast to mutual funds that

charge fees based on a fixed percentage of assets under management, hedge funds typically levy

additional performance-based fees equal to 20% or more of realized capital gains and capital

appreciation. The resulting incentives for management firms to strategically transfer performance

to hedge funds from mutual funds has attracted the attention of the U.S. Securities and Exchange

Commission (SEC), which has expressed concern about the welfare of mutual fund investors in

side-by-side arrangements with hedge funds.2 Our study investigates whether these concerns are

justified.

1 Chevalier and Ellison (1997) and Sirri and Tufano (1998), among others, find that investor inflows are

more sensitive to top performing funds versus lower performing funds. Chevalier and Ellison (1997) show

that the convex flow-return relation is particularly strong for young funds.

2 U.S. Securities and Exchange Commission (September 2003) articulates these concerns.

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Management firm favoritism that transfers performance from mutual funds to hedge

funds can take many forms. We list six examples: First, management firms can front run the

execution of hedge fund trades ahead of mutual fund trades.3 Second, in a practice known as

‘cherry-picking’, decisions about how a trade is allocated can be delayed, with trades

experiencing favorable subsequent price movements allocated to hedge funds. Third, rather than

allocating the average price paid in a bunched trade, shares bought at the lowest price and shares

sold at the highest price can be allocated to hedge funds. Fourth, mutual funds can pay trade

commissions inflated by soft dollar payments, but hedge funds can benefit from services

purchased with the soft dollars.4 Fifth, management firms can allocate disproportionately more

underpriced IPO shares to hedge funds and fewer to mutual funds. In the sixth and final example,

the favoritism is quid pro quo: For hedge fund investors who agree to commit assets for extended

periods, management firms extend market timing or late trading privileges in the mutual funds

they oversee.5 In this last example, the wealth transference may be more circuitous than in the

other examples, but the end result is that hedge fund investors’ market-timing or late-trading

profits come at mutual fund investors’ expense.6

Direct empirical detection of these acts of favoritism using transactions level data is

impossible for us given that the data is not publicly available.7 Thus we conduct a number of

3 In conversations with industry practitioners, we learned that at least some management firms distribute

stock “hot lists” to mutual fund and hedge fund managers. The stocks that appear on these hot lists are the

best picks generated by the management firm’s research group. If management firms favor hedge funds

over mutual funds in the order filling process, reported mutual fund holdings will not reflect the most

recent valuation beliefs. Moreover, if the management firm’s trades move stock prices, then hedge funds

will transact at better prices than mutual funds. In this scenario, mutual fund holdings returns will thus be

negatively affected.

4 Greenwich Associates (2006) reports that in 2004, about 75% of mutual funds paid trade commissions

that were inflated by soft dollar payments. In 2005, more than 60% of U.S. management firms that used

soft dollars indicated that other departments within the firm benefited from services paid with equity trades.

5 The SEC’s case against Alliance Capital, discussed later, is a specific example of such favoritism.

6 Zitzewitz (2003) estimates around $5 billion annual losses for long-term mutual fund investors due to

market timing. Zitzewitz (2006) finds significant evidence of late trading behavior in 39 out of 66 mutual

fund families in his sample, and suggests that many of those families were aware of such illegal behavior in

their funds. He estimates annual mutual fund investor losses at about $400 million due to late trading.

7 Recognize that if direct detection was possible, litigation concerns would likely dissuade side-by-side

management firms from such acts.

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empirical tests that rely on indirect evidence of favoritism. Our first set of empirical tests is based

on the premise that all of the above acts of favoritism negatively affect the performance of the

mutual funds in the side-by-side arrangement. If side-by-side management firms engage in

strategies that transfer wealth, then side-by-side mutual funds ought to exhibit returns that

underperform those of similar unaffiliated mutual funds (i.e. those run by management firms that

do not also run hedge funds).

In addition to examining reported returns, we examine holdings returns, calculated as the

buy-and-hold return on a portfolio comprised of the most recently disclosed securities, and return

gaps, defined as reported returns less holdings returns.8 Acts of favoritism that occur between

holdings reporting intervals, such as front running, cherry picking, unbalanced bunched trade

allocations, inequitable commission and soft dollar allocations, preferential IPO allocations,

market timing, and late trading, affect reported mutual fund returns but not holdings returns.

Thus, return gaps capture the impact of these unobserved short-term acts of favoritism on mutual

fund returns. Although holdings returns are not affected by these short-term acts, holdings

returns may be negatively affected if hedge funds are prioritized when moving into or out of

illiquid positions, resulting in mutual fund reported holdings not reflecting the most recent

valuation beliefs.9

We also consider the possibility that policies designed to protect side-by-side mutual fund

investors from conflicts of interest differ considerably across management firms. Strong

protections contribute to evenhanded treatment in portfolio decisions and trade execution,

8 Studies that examine actual mutual fund returns and holdings returns include Grinblatt and Titman (1989);

Wermers (2000); Frank, Poterba, Shackelford, and Shoven (2004); Meier and Schaumburg (2005); and