Hedge fund share class restrictions may have unintended consequences, research suggests. Fund flow affects future performance, a fall of up to 5.6% was observed in funds where there were outflows.

Share class restrictions in the hedge fund industry may have unintended consequences, disadvantaging some investors who are not aware of future fund flows, concludes research by Ronnie Sadka of Boston College’s Carroll School of Management in the US and Gideon Ozik of the Edhec Business School.

Managers and significant investors who know in advance about money exiting a fund because of the advanced notice required in a restricted share class fund could take advantage of that knowledge. This may disadvantage shareholders remaining in the fund who are not aware of the outflows in advance, say Sadka and Ozik. Their findings* were presented at a research conference in Paris sponsored by Lyxor and NYSE Euronext.

Fund flow in turn predicts future fund returns for share-restricted funds, especially among funds with low levels of corporate governance, says Sadka.

Managers may be tempted to pull their own investment in a fund if they know a significant investor is redeeming. Sadka and Ozik found some direct evidence for such behaviour by managers, although they concede there may be other reasons for a manager withdrawing money from a fund.

One example cited by Sadka and Ozik concerns State Street. On February 4, 2010, State Street Bank and Trust, a manager of the Limited Duration Bond Fund, agreed to pay more than $550 million to settle a complaint brought by the SEC.

At the same time, certain insiders, including the internal advisory groups and State Street Corporation pension plan, learned that State Street was going to sell a significant amount of the fund’s distressed assets to meet expected redemptions. State Street’s internal advisory groups subsequently decided to redeem or recommend redemption from the fund and the related funds for their clients.

State Street Corporation’s pension plan was one of those clients. State Street sold the fund’s most liquid holdings and used the cash it received from these sales to meet the redemption demands, leaving the fund with largely illiquid holdings. Before these sales, the redeeming shareholders controlled approximately 20% of the fund’s shares. By early August 2007, virtually all these shares were redeemed.

This case, say Sadka and Ozik, lays out a series of events by which ‘inside’ information about anticipated fund flow is used by certain investors to redeem their shares prior to less informed investors.

The research also found that funds with low corporate governance, based on four criteria including domicile and Securities and Exchange Commission registration, were more likely to have managers inclined to act on future flow information to withdraw their own investment in the fund.

Investors need to be aware of this possibility and guard against it in tighter documentation. One incentive for investors to be more attentive to this problem is the drop in performance Sadka and Ozik observed in funds where there were significant outflows. Performance up to 5.6% lower per year was observed in funds where there was a net outflow.

Looking at funds where a manager reduced his stake in the fund over a 12-month period, there was a decrease in fund performance.

* Skin in the Game versus Skimming the Game: Governance, Share Restrictions, and Insider Flows by Gideon Ozik, Edhec Business School, and Ronnie Sadka, Boston College, Carroll School of Management.