Sports stars often attribute motivation in the early parts of their career to their humble backgrounds. For those successful enough to amass significant wealth, their hunger and drive is often questioned later in their career: they have less to gain, and less to prove. This month, Stable explores this phenomenon in the world of hedge funds.
Fund managers are more likely to come from wealthier backgrounds: research has found that the median value of a fund manager’s childhood home was 2.5x greater than state averages1. However, from a performance perspective, the same study found that mutual fund managers whose parents were from the least wealthy quintile outperformed those from the wealthiest quintile by over 1% per year.1 The popular explanation for this is that managers from the least wealthy backgrounds had to work the hardest and demonstrate greater ability than their wealthier counterparts to get into the world of managing funds. Therefore, there is a quality bias: only the cleverest and hardest working individuals from poorer backgrounds become fund managers, whereas there is a wider spectrum of ability and drive amongst fund managers from wealthier backgrounds. This echoes the popular explanation for the outperformance of female managers outlined in our piece on Gender. This explanation was supported by the finding that those from poorer backgrounds had to perform better to be promoted than those from wealthier backgrounds.1
It is worth noting that the empirical evidence cited above was based on mutual fund managers and not hedge fund managers – and so caution must be taken when generalizing between the two given the different incentive structures, as we saw in our “Youth” article. When seeding, we pay close attention to what drives managers to perform. We analyse incentives of all kinds, and have found many investors underestimate the role non-financial incentives play compared to financial incentives. Incentives may differ for managers of different wealth levels. Appetites and aversions to risk do not follow a linear utility function.2 Specifically, it may be that less wealthier investors are more incentivised to return, or that wealthier investors are incentivised not to lose what they already have.
Studies show that when the amount of money at stake is higher, and potential gains and losses become larger, individuals become more risk averse despite the same odds.3,4 Crucially, it is when the amount of money at stake is higher on a dollar basis, not on a relative % basis.3 Theoretically, this is because each additional unit of profits has less utility than the last; and each unit of losses has more utility than the last – a concave relationship. When stakes are higher, individuals become more risk averse.
This has profound implications on the investment management industry: it would dictate that on average managers who are wealthier and have more personal capital at risk will likely take less risk and underperform. Hedge fund performance data supports this: smaller funds outperform.5 Wealthier managers want to remain wealthy, smaller, less wealthy managers want to become wealthy (by performing!).
What therefore is the optimal amount of wealth for a manager to have? Should allocators prefer a larger figure when a manager is asked how much ‘skin in the game’ they have? Obviously, greater risk appetite and motivation needs to be balanced with commercial and common-sense considerations: personal wealth (if acquired from investment performance) is an indicator of success and manager quality, and shows that interests between an investor and a manager are more aligned. There is obviously no correct answer, but it is more of a balanced debate than the common one-sided belief that the more personal wealth invested in the fund the better. We believe that the most relevant measure is what proportion of a manager’s wealth is invested in the fund, not necessarily the amount. We want the investment to be as large a percent as possible, whilst allowing for some cash buffer so the manager is unlikely to need to take money out of the fund, and be able to reinvest the majority of his performance fee.
At Stable we take time to understand all aspects of a manager’s background, including their childhood background and current wealth levels. Whilst a manager from a poorer background may statistically be more likely to outperform compared to a manager from a wealthy background if selected randomly, we do not proactively favour those from poorer backgrounds. We do however think about the role of wealth in a manager’s motivation to help us improve our due diligence process. For instance, we would spend more time assessing a manager’s motivation, drive and risk appetite if they had $1B in the bank; and likewise, would spend more time understanding a manager’s prior track record if they had very little acquired wealth to show for it. Great managers are incentivised by a passion for what they do. The thrill of competing and winning can often be a large source of motivation. One has to distinguish true passion for excellence from a thirst for status and recognition. Generating wealth for most is a welcome side-effect, but they would probably still do what they do even if managing a hedge fund was a less lucrative profession.