Gideon Ozik
EDHEC Business School

Ronnie Sadka
Boston College - Carroll School of Management

AFA 2012 Chicago Meetings Paper

Abstract

Share restrictions in the hedge-fund industry are often introduced as means of protecting the common interest of investors. Yet, this paper advances that such restrictions induce information asymmetry between managers and their clients about future fund flows. Fund flows, in turn, predict future fund returns for share-restricted funds, especially among funds with low levels of governance and funds managing insiders' wealth, providing managers incentive to trade in advance of their clients. Some direct evidence for such managerial action are presented, as well as additional consistent evidence from the flows of funds within the same family. The evidence suggest that private information about a fund, not only about the fundamental value of its assets, may constitute material information. Such private information engenders potential conflict of interest between fund managers and investors, with implications for proper fund governance and disclosure policy concerning managerial actions.

Press Release

Armed with insider knowledge, managers of share-restricted hedge funds sell off their own holdings ahead of their investors in order to avoid low returns produced by an outflow of shareholder dollars, according to a new study by researchers from Boston College and EDHEC Business School in France.

The practice, known as front running, pits the interests of managers against those of investors in hedge funds where shareholder actions are limited by contract and there is scant disclosure of fund details. Managers act in advance on the information they possess, and can pass it along to preferred clients to shield them from declining returns, which the researchers say can be predicted by the flow of funds.

Analyzing rarely-seen data from the privately held funds, Boston College Professor of Finance Ronnie Sadka and EDHEC researcher Gideon Ozik identified 56 events where managers reduced their holdings, actions that were subsequently followed by a significant out flow of other investors' money. Further studying a larger sample of thousands of funds, the researchers conservatively estimated that managers in the hedge fund industry could have effectively sheltered approximately $2.4 billion dollars from reduced returns that Sadka and Ozik say are directly linked to the withdrawal of investor dollars from a hedge fund.

The findings follow a number of high profile cases in recent years that spotlight managers of the multi-billion dollar funds who shielded their own holdings from losses or tipped off preferred clients in advance of an investor's departure from a fund. Earlier this month, billionaire hedge-fund manager Philip Falcone's Harbinger Capital Partners was accused of providing preferential treatment to Goldman Sachs and other investors.

"The evidence suggests that private information about a fund, not only about the fundamental value of its assets, may constitute material information," report Sadka and Ozik. "Such private information engenders potential conflict of interest between fund managers and investors, with implications for proper fund governance and disclosure policy concerning managerial actions."

In share-restricted hedge funds, investors' actions are limited in order to protect the common interests of all investors in a fund. The restrictions, such as lockup periods or redemption-notice periods, provide an incentive to retain assets in a fund, allow managers to slowly acquire or sell positions and reduce the impact of trading-induced price pressures.

But these share restrictions produce a lopsided exchange of information between managers and their clients about future fund flows, said Sadka.

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