Stockholm (HedgeNordic) – A recent study conducted by NYU Stern Professor of Finance Arpit Gupta and co-author Kunal Sachdeva of Columbia Business School finds that hedge funds with larger investments by insiders outperform those funded with external capital. The study also finds that funds run by managers with more “skin in the game” exhibit superior return persistence, and their capital flows are less sensitive to return variability.
The study, titled “Skin or Skim? Inside Investment and Hedge Fund Performance,” uses a survivor-bias-free dataset of U.S. hedge funds to examine the role played by inside investment in fund performance. The main conclusion from the study was that funds with higher internal investment sport higher excess returns. The results suggest that a fund wholly owned by insiders outperforms a fund backed solely using external capital at a rate of 36 basis points a month.
The study also finds that funds with sizeable internal investment experience greater persistence of high excess returns, as these vehicles, operate trading strategies further from their capacity constraints. In other words, funds backed by internal investment do not accept as many inflows as funds supported mostly by external capital. Arpit Gupta and Kunal Sachdeva conclude that funds manage capacity constraints better when managers have personal capital invested in their strategies.
One main takeaway for fund managers and investors from the study relates to the importance of managers having “skin in the game” or personal capital invested in their funds. In fact, this should serve as the primary means of aligning the interests of fund managers with the interests of their investors. After all, a pivotal component of hedge fund compensation is the channel of returns on personally invested capital.
Another important takeaway is that hedge fund investors want to make sure the funds they are investing in do not grow too large. More importantly, the study documents that funds with sizeable internal investment defy the laws of capacity gravity. While funds typically tend to perform poorer as their assets under management grow, the high returns enjoyed by funds backed with 20% or more insider allocations do not lead to excess inflows, and their excess returns are persistent as a result.
Picture (c): Shutterstock Juan R. Velasco