A number of studies have noted over the years that companies with the highest insider ownership, tend to outperform peers. The logic behind this conclusion is easy to understand. Managers who own a significant chunk of shares are unlikely to embark on value-destructive acquisitions or put to their company at risk as they stand to lose more than most other investors.
The same logic should be true of investment funds, particularly hedge funds and partnerships. If the chief investment officer, founder or managing partner owns a significant equity stake in the business, they are less likely to take excessive risk and should, in theory, achieve better returns for investors.
After all, not only will they benefit from extra management and performance fees, they will also see an uplift in their wealth.
Hedge Funds With High Insider Ownership Produce Better Returns Says New Study
Arpit Gupta of NYU Stern and Kunal Sachdeva of Columbia Business School set out to test this theory, and they’ve recently published their findings in a paper called, Skin or Skim? Inside Investment and Hedge Fund Performance.
The duo considered a comprehensive data set of hedge funds and ownership data using Form ADV data from the SEC. This regulatory form requires all hedge funds with assets over $100 million (in most states) to disclose yearly the fraction of fund returns held by insiders, giving a “genuinely survival bias-free and comprehensive dataset on hedge funds.”
The fund considers all hedge funds that have filled a ADV disclosure after 2011, after changes in disclosure imposed by Dodd-Frank. Form ADV information is linked with information on hedge fund returns obtained from a combination of three datasets: Barclays, EurekaHedge, and CISDM to produce the most comprehensive data set. After considering the data the authors conclude:
“We find that funds with greater investment by insiders outperform funds with less “skin in the game” on a factor-adjusted basis; exhibit greater return persistence; and feature lower fund flow-performance sensitivities. These results suggest that managers earn outsize rents by operating trading strategies further from their capacity constraints when managing their own money.”
Gupta and Sachdeva’s study uses a cutoff of 20% insider ownership and what they find is that funds with less than 20% insider ownership tend to grow after having high excess returns, and then have worse returns. On the other hand, funds with more than 20% insider ownership tend to stay the same size and continue to outperform. Both size, risk taking, and manager rewards are a factor here. As the study notes:
“We find that funds with little inside capital operate according to standard Berk and Green (2004) logic: good returns are followed by large fund inflows, so there is little predictability in excess returns. However, we find that funds with greater inside investment do not follow this pattern. For this subset of funds, high returns do not lead to excess inflows; instead excess returns are persistent. The joint behavior between fund flows, performance, and inside investment suggests that capacity constraints are an important driver of hedge fund performance; and that managers of hedge funds choose to deploy less capital (and so gain greater alpha) when their own personal capital is involved.”
Gupta, Arpit and Sachdeva, Kunal, Skin or Skim? Inside Investment and Hedge Fund Performance (June 07, 2017). NYU Working Paper No. 2451/38717. Available at SSRN: https://ssrn.com/abstract=2983030