INDIRECT ADVERTISING FOR HEDGE FUNDS
by Sugata Ray
One of the measures in last year’s JOBS Act contemplated lifting the ban on advertising by hedge funds, while retaining investor wealth, income and sophistication thresholds.1 While the JOBS Act passed last year, this particular measure was temporarily stayed for a comment period and further debate, with the SEC citing investor concerns. Presumably, the worry is that even wealthy, sophisticated investors may be lured into hedge funds through such advertising without fully understanding the risks involved. The question of lifting the ban remains an open one at the time of writing.
We study what amounts to “backdoor” advertising by hedge funds over the last 6 years, and use results to inform the decision to lift the ban (see “Alternative marketing for alternative investments,” Yan Lu, David Musto and Sugata Ray, Working Paper, 2013, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2260370). We focus on advertising by mutual fund companies that also own and operate hedge funds. Since mutual fund advertising is legal (and regulated), we use a database of such advertising to examine whether (1) such advertising factors in the hedge funds that are operated by the parent company in any way, and (2) whether advertising the mutual fund and/or the parent company generally has any effect on the hedge funds’ inflows.
Our first main result is that advertising ramps up after abnormally low hedge-fund flows, indicating that management companies advertise to combat hedge-fund asset shrinkage. Looking more closely, we find that the type of advertising that increases is advertising of the whole company, as opposed to the company’s mutual funds.2 So it appears that management companies use advertising to create goodwill that reflects at least partly on its unadvertisable products, particularly when their stars fade.
Our second main result is that the advertising works for the hedge funds: those whose parents advertise enjoy significantly more subsequent net flows, approximately 6% more per year, than do similar funds whose parents do not advertise. And our third main result is that performance is somewhat worse: the hedge funds whose parents advertised subsequently underperform, by about 2%/year, those whose parents did not advertise.
In addition to being limited to investors that are “qualified,” hedge funds currently cannot advertise (or “generally solicit”). “Qualified” investors are investors that meet certain income and/or wealth thresholds.
Our advertising database, Ad$pender, categorizes advertising into a number of different types, from product, and even sub-product specific ad spend, to general, company level promotion. We aggregate these categories into two broad types: company level advertising, which advertises the overall parent company brand and product level advertising, which advertises individual mutual funds in the complex.
A closer look at the effect on subsequent flows reveals mutual-fund-level, rather than company-level, advertising has the stronger influence. This raises the question of the mechanics of this ‘back-door’ advertising. Mutual-fund-level advertising would appear to bring attention to a mutual fund that must be redirected upon contact: a qualified investor who calls about the mutual fund could be cross-sold the hedge fund at that point, or maybe sold the fund he called about, and cross-sold later. The response to company-level advertising is less likely to involve cross selling. Thus, the mechanics of back-door advertising involve a significant amount of redirecting investors who called about something else.
Our results indicate that hedge funds affiliated with mutual funds enjoy an advantage over those without. Thus, from a policy perspective, lifting the ban on hedge-fund advertising would level the hedge-fund playing field. Lifting the ban would also help investors match with the right funds, as investors could compare track records more readily, as they do with mutual funds, and may be less affected by the arguably less relevant performance of affiliated mutual funds. The sub-par post-advertising performance for hedge funds is not a great track record for advertising to date, but this may reflect the peculiarities of advertising through the back door.
1) In addition to being limited to investors that are “qualified,” hedge funds currently cannot advertise (or “generally solicit”). “Qualified” investors are investors that meet certain income and/or wealth thresholds.
2) Our advertising database, Ad$pender, categorizes advertising into a number of different types, from product, and even sub-product specific ad spend, to general, company level promotion. We aggregate these categories into two broad types: company level advertising, which advertises the overall parent company brand and product level advertising, which advertises individual mutual funds in the complex.