Hedge Fund Manager's Alma Mater Matters
Hedge fund investors tend to get superior performance from younger, better-educated managers with high motivation.
ANN ARBOR, Mich.---Hedge fund investors seeking superior performance are well-advised to select younger, well-educated fund managers who are highly devoted to their jobs, says a University of Michigan business professor.
According to a new study by Haitao Li, assistant professor of finance at the U-M's Ross School of Business, and colleagues Xiaoyan Zhang of Cornell University and Rui Zhao of Columbia University, the personal, educational and professional characteristics of fund managers greatly impact hedge fund returns.
"The performance of a hedge fund depends crucially on both the investment strategies it follows and the talent of its managers in implementing such strategies," Li said. "Just like any entrepreneurial activity, some hedge fund managers are better than others at making investment decisions."
Li and colleagues collected information on the characteristics of the lead manager of about 1,000 funds from 1994 to 2003. The six traits they examined include: the manager's age, the number of years he or she has been working, the length of his or her tenure at a specific hedge fund, the composite SAT score for the manager's undergraduate university, whether he or she has a CPA or CFA, and whether he or she has an MBA degree. Broadly speaking, the SAT, CPA/CFA and MBA characteristics represent intelligence and education. The age, work time and tenure represent working experience and career concern.
Based on their dataset of manager characteristics and various risk-adjustment models, the researchers found that manager education and career concern have a strong impact on different aspects of hedge fund performance, such as fund risk-taking behaviors, raw and risk-adjusted returns and fund flows. Managers from higher-SAT universities tend to take fewer risks and have higher raw and risk-adjusted returns, while younger managers also tend to have higher returns and more inflows, but take more risks.
These results, they say, are consistent with their assumption that more highly educated managers are better at performing their jobs and thus can achieve higher returns at lower risk exposure. The findings also support their contention that younger managers have stronger incentives to work hard at their jobs and to establish their careers. Consequently, they are more willing to take risks and tend to perform better than older, more established fund managers, who take significantly fewer risks.
When everything else is the same, a manager from an undergraduate institution with a 200-point higher SAT can expect to earn an additional 0.73 percent raw excess return per year, and a manager with five years less working experience can expect to earn an additional 0.54 percent raw return per year. Similarly, a 200-point increase in SAT leads to a 1.91 percent higher growth rate in assets under management per quarter.
"All in all, our findings strongly suggest that hedge funds are very different from mutual funds," Li said. "Talent and motivation should be important considerations in selecting hedge fund managers."
Hedge funds, which are predicted to have $3 trillion under management globally by 2008, use aggressive strategies not available to mutual funds, including selling short, leverage, program trading, swaps, arbitrage and derivatives. They are not subject to the same level of regulation as mutual funds and thus enjoy greater flexibility in their investment strategies.
While mutual funds charge a management fee proportional to assets under management (usually 1-2 percent), most hedge funds charge an incentive fee, typically 15-20 percent of profits, in addition to a fixed management fee of 1-2 percent. Moreover, hedge fund managers often invest a significant portion of their personal wealth in the funds they manage. And many hedge funds have a high watermark provision, which requires managers to recoup previous losses before receiving incentive fees.
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