Hedge Fund Managers' Higher SAT Scores Lead To Better Performance, Study Says

Submitted by Dmitri Davydov on Sun, 2007-09-09 05:46.

IF investors want a performance edge in their hedge funds, they may want to do a little background research on the managers: look for those who attended colleges with relatively high SAT scores.

Funds run by such managers regularly posted higher returns, according to a study, “Investing in Talents: Manager Characteristics and Hedge Fund Performances,” which has been circulating since May as an academic working paper. Its authors are Haitao Li, an assistant professor of finance at the University of Michigan; Xiaoyan Zhang, an assistant professor of finance at Cornell; and Rui Zhao, a research associate in the portfolio management group of BlackRock Inc., the asset management company. A version is at http://ssrn.com/abstract=990753.

To investigate the relationship between hedge fund returns and the academic credentials of their managers’ colleges, the researchers focused on more than 4,000 hedge funds that operated at some point from 1994 to 2003. They built a database that included not only the performance of each fund, but also the average combined SAT score, verbal and math, of the undergraduate college or university of the fund’s lead manager. After eliminating funds for which requisite data were unavailable, the database contained just over 1,000 funds.

The researchers found a “strong positive relation” between a hedge fund’s performance and the average SAT score at its manager’s school. To put the relationship into context, the researchers offer this illustration: “Everything else being the same, a manager from an undergraduate institution with a 200-point higher SAT — for instance, from Yale University, with an SAT of 1480 at the end of our study period, instead of from George Washington University, with an SAT of 1280 — can expect to earn 0.73 percent more per year.”

This higher return might not be all that noteworthy had it been produced with markedly higher risk. But the researchers were able to dismiss this possibility: the average hedge fund managed by someone who went to an institution with higher SAT scores incurred significantly less risk than one whose lead manager attended an institution with lower average scores.

So, on a risk-adjusted basis, the manager who went to the school with higher scores is even further out front.

What accounts for the researchers’ findings? In an interview, Professor Zhang said it was possible that managers who attended more-elite institutions had better contacts in the business and investment arenas, giving them access to particularly promising opportunities. But, though she and her fellow researchers could not measure the effect of such better networking, she said she suspects that it plays only a minor overall role. “The dominant force,” she contended, “will be the superior talents and higher intelligence levels of the average student at higher-SAT institutions.”

One potential objection to the findings is that similar studies of mutual fund managers have found little correlation between their performance and their colleges’ SAT scores. But this difference between mutual funds and hedge funds makes sense, according to Professor Zhang, because of the ways their managers are compensated.

THE pay of mutual fund managers is typically based solely on assets under management, she pointed out. So these managers have an incentive to let their funds grow beyond a size that they can manage profitably. This tends to eliminate the better performance that would otherwise be associated with attending a college with higher test scores, she argued.

Hedge fund managers, by contrast, typically earn much more from sharing in their funds’ profits than from asset-based fees, according to Professor Zhang, at least when their funds are performing well. As a result, they have a strong incentive not to let their funds grow too big, so the test-score effect is not eliminated.

The investment implication of the new research goes well beyond the hedge fund arena to the choice of any investment adviser.

As the researchers conclude their study, “a manager’s talents and motivations should be important considerations” in deciding whether to let him or her invest your money.

[Via - NYTimes.Com

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