Do hedge funds gain from mutual funds' brain drain?

ISBInsight: Why is talent an issue for the asset management sector? How did you start investigating these questions?
Prachi Deuskar: The asset management profession provides an easily trackable performance metric for individual fund managers and for a rapidly expanding industry. The relative absence of regulations on compensation contracts and trading strategies, as well as the ability to charge an incentive fee, has led to a rapid expansion of the hedge fund industry. This has, in turn, lured away talented managers from the mutual fund industry, which is more regulated and does not incorporate incentive fees. Our research investigated the question: How do mutual funds respond to this and overcome any potential handicap due to regulation? What other opportunities could mutual funds consider offering their top talent?

Retaining skilled managers while firing incompetent ones is crucial to maintain productivity. At the same time, retention policies must take into account changing outside opportunities for the employees.

According to our analysis, rewarding good performance not just with additional money but with increased responsibility proves critical to the retention of skilled workers, especially in the context of the mutual fund industry’s competition for talent with the rapidly growing hedge fund industry.

Q. Which metrics did you consider in analysing managerial turnover in mutual funds and hedge funds?
The research addresses two sets of factors that affect managerial turnover. These include both internal signals affecting the retention and promotion of managers as well as external signals like the impact of industry/ market conditions and the scarce supply of skilled labour. Towards this end, our paper did a comparative study of both signals side-by-side. It compared managers in the same firm with both hedge funds and mutual funds management responsibilities and those that completely switched and moved industries.

The sample set consisted of 287 mutual fund managers who joined hedge funds between 1993 and 2006. Of these managers, 157 side-by-side managers retained their jobs in the mutual fund industry while simultaneously managing both mutual funds and hedge funds. The remaining 130 managers were complete switchers who severed all ties with the mutual fund industry to join hedge funds. To capture a manager’s performance at a mutual fund, we referred to the average return of other funds with the same investment style and facing the macro-economic factors. The remaining or residual return can be understood as a return on the manager’s own talent.

Q. Could you elaborate on some talent retention strategies that mutual funds are using?
We found that mutual funds are able to retain managers with good performance in the face of competition from a growing hedge fund industry. Side-by-side options, i.e. retaining a mutual funds role while simultaneously managing hedge funds, is one way to incentivise mutual fund managers who demonstrate superior performance. Such additional side-by-side options make it possible for high performing mutual fund managers to extend their scope of duties in line with organisational priorities while at the same time sending a strong internal talent retention signal.

Interestingly, we found that the mutual fund industry was more likely to offer side-by-side arrangements to top performers when the hedge fund industry was growing rapidly. Moreover, mutual funds that offered the side-by-side arrangement to managers with better performance and severed their ties with managers performing poorly did not lose their existing talent to hedge funds. In other words, better-performing mutual fund managers are typically retained and promoted while poorly performing ones are fired. Our findings point to the fact that managers leaving the mutual fund industry have a history of poor performance.

Q. What kind of employment prospects do the poor performers within mutual funds face?
Given a growing hedge fund industry, the poor performers find jobs with smaller and younger hedge fund companies. This could be due to a better fit with hedge funds than mutual funds. Or, it could be due to the possibility of lowered hiring standards during periods of rapid growth (the number of hedge funds increased from around 2,400 to 3,900 from 1995 to 2000 and to 8,700 in 2005) as the switchers continue to perform poorly relative to other managers in hedge funds. The bulk of the managers in our study who left the mutual fund industry to join hedge funds did so during the hedge fund boom period of the early 2000s. In other words, both good and bad managers get a better deal when the hedge fund industry is growing.

Q. Could you spell out some takeaways for the asset management labour market from your study?
At the outset, I should note that the analysis was done in the U.S. market at a time when the hedge fund industry was growing fast. The Indian money management industry is not at the stage of maturity as the U.S. industry. However, the broad insights from the paper are still valid.

Labour satisfaction and retention is a major challenge for managers, especially in the asset management industry, given its rapid growth in the last decade. Mutual funds have been threatened with an exodus of managers to the hedge fund industry. Is this an indication of the ability to time the labour market or of the skills to generate a superior performance? Our findings suggest that mutual funds do not lose their best-performing managers due to competition from hedge funds. In fact, managers leaving the mutual fund industry have a history of poor performance. Thus, it is more about timing the market than about skills. Poorly performing mutual fund managers continue to underperform their new peers.

For high performing managers, employee retention and employee satisfaction are interlinked. Just managing mutual fund portfolios might not suffice for these top performers. By offering a side-by-side arrangement to manage diverse portfolios, the mutual fund industry can retain its best performers. Thus, employee retention is no longer simply an outcome but a strategy that must be pursued.

About the research:
Deuskar, P., J. M. Pollet, Z. J. Wang and L. Zheng, 2011. The good or the bad? Which mutual fund managers join hedge funds? Review of Financial Studies, 24 (9): 3008-3024.

About the author:
Mridula Anand is a Senior Research Manager with the Srini Raju Centre for Information Technology and the Networked Economy (SRITNE) at the ISB.

[This article has been reproduced with permission from the Indian School of Business, India]