Hedge and Mutual Funds' Fees and the Separation of Private Investments

TL;DR

This paper models how fund managers allocate assets between fund investments and private wealth, showing that under certain conditions, these portfolios depend solely on their respective opportunities and do not provide diversification benefits.

Contribution

It demonstrates that fund managers' private and fund portfolios are independently determined by their respective investment opportunities, with no diversification gains from private investments.

Findings

Fund portfolios depend only on fund opportunities.

Private wealth portfolios depend only on private opportunities.

No diversification gain from private investments.

Abstract

A fund manager invests both the fund's assets and own private wealth in separate but potentially correlated risky assets, aiming to maximize expected utility from private wealth in the long run. If relative risk aversion and investment opportunities are constant, we find that the fund's portfolio depends only on the fund's investment opportunities, and the private portfolio only on private opportunities. This conclusion is valid both for a hedge fund manager, who is paid performance fees with a high-water mark provision, and for a mutual fund manager, who is paid management fees proportional to the fund's assets. The manager invests earned fees in the safe asset, allocating remaining private wealth in a constant-proportion portfolio, while the fund is managed as another constant-proportion portfolio. The optimal welfare is the maximum between the optimal welfare of each investment opportunity, with no diversification gain. In particular, the manager does not use private investments to hedge future income from fees.