There is a paradox at the heart of an investor’s search for funds that can produce attractive returns. Effective diligence must seek to overcome a powerful dynamic in investment management, which is neatly summed up with the Groucho Marx maxim: “I refuse to join any club that would have me as a member”.

Suppose there is a mutual fund that investors agree has a very skilled manager. As a result of that skilled manager, that fund generates positive alpha and beats the market. All investors are going to want to invest in that fund, and one would expect to observe an inflow of capital. As mutual funds charge fees as a percent of assets under management (AUM), the manager benefits from the larger AUM.

However, the more capital a manager has, the harder it is for that manager to beat the market. Intuitively, the larger the portfolio, the larger the trades, and the more the fund moves the price of securities against it when it trades. The alpha of the manager goes down as either market impact costs increase, the manager admits less attractive ideas to the portfolio, or, aware of the current strategy’s limits, the manager embraces new strategies for which they may be less skilled ("strategy creep”). Capital keeps flowing in until investors no longer want to invest, which happens when the return of the mutual fund is the same as their next best investment opportunity, in other words, the market.

Therefore, competitive market pressures drive alpha, from the investor’s perspective, to zero. The potential of this "alpha decay" to cause observed returns to deteriorate is an iron law of investment management.

Preserving alpha

Are hedge funds susceptible to alpha decay? Similar alpha-reducing competitive dynamics apply to hedge funds, but hedge fund managers may have good reasons to constrain capital inflows:

1. Hedge fund fees typically consist of a performance fee and a fee on capital. To the extent that growing fund AUM adversely impacts returns, the earned performance fee is reduced, which may reduce the incentive of the hedge fund manager to accept more capital.
2. Unlike mutual funds, hedge fund principals often commit personal capital to their fund. This serves to align interest with investors: the personal balance sheet of the manager suffers if expanded AUM causes returns to deteriorate.
3. Creating scarcity may provide strategic benefits to the manager. Hedge funds can select which investors to admit to their fund. Constraining access imposes an implicit cost to withdrawals by making it difficult to regain access, allowing managers to attract investors who are expected to be reliable, long-term partners and discourage those inclined to be overly reactive to current performance. University endowments, philanthropies and prominent family offices are often regarded as stable limited partners and granted access.

For these reasons, hedge fund managers may find it advantageous to exercise discipline about expanding AUM.

Despite these incentives to constrain capital, some managers may nonetheless conclude the benefits of greater AUM outweigh the costs. The manager of a high-beta hedge fund may find it in their interest to expand AUM despite the performance fee. Even a fund exercising strong AUM discipline can experience alpha decay, as their success can lead to imitation. For example, skilled younger hedge fund employees may spin-out to start their own franchises. If the strategy of the spin-out strongly resembles that of the parent, total strategy AUM increases and investor returns at both funds diminish. For this reason, highly successful funds lock-up their employees with stringent non-compete and intellectual property provisions in employment contracts.

Alternatively, the manager might have confidence that they can grow without impacting returns negatively and discover belatedly such confidence was misplaced. Just as investors must separate luck from skill in identifying strong managers from good track records, a manager must unravel whether deteriorating performance is due to bad luck, or the alpha decay from larger AUM. If managers are inadequately aligned with investors, they are not well-incentivised to attribute responsibility correctly.

Avoiding misalignment

While the phenomenon of alpha decay in mutual funds is well-studied, it is less easily studied in the case of hedge funds. Hedge fund-specific returns, and data on assets under management, are generally only available to the fund’s investors and even then, typically only during the period of investment.

So how can investors spot a manager that may not act in their best interests? First, they can examine the manager’s compensation structure (fees and personal capital commitment) to evaluate alignment of interest.

Second, they can assess if the fund’s AUM is below the level that supports its strategy without negatively impacting returns. If so, there is scope for AUM to grow without alpha decay.

Third, do the liquidity provisions of the fund permit withdrawal in case any of the above assessments turn out to be incorrect?

And finally, mindful that attractive funds may be those who exercise good AUM discipline, investors can aim to access funds that appear to be closed. Access to such funds is extremely difficult and may require prior relationship, or having skills or attributes with which the hedge fund may find it desirable to consult or be affiliated.

This brings us back to Groucho Marx, whose maxim is equally helpful expressed differently– try to join clubs that aren’t inclined to accept new members.  

David Bizer is a managing partner at Global Customised Wealth, a London-based wealth manager that provides investors with portfolios that seek to generate attractive risk-adjusted expected returns.  

‍

By David Bizer

Read the Hedge Week Article here: https://www.hedgeweek.com/2023/03/27/319983/groucho-marx-and-investment-management-lessons-manager-selection

‍