Monday, June 11, 2007

Call your buddy

New research shows that mutual fund managers get a higher return from investments in companies where one of the top execs is someone they went to school with. The effect is most pronounced with Harvard Business School alumni. Having worked with a lot of HBS guys, I am not surprised :-)

This kind of study can only be done with mutual funds and public companies, where all the records are available. Whatever is going on here is probably going on even more in private equity and hedge funds, but isn't easy to quantify. Clearly, social networks like school ties give access to information that average investors don't have. As they say in poker, if you don't know who the sucker is at the table, it's probably you...

PS I see a trading strategy here. Set up your own real-time database of fund pm and C-exec educational bios, and mirror all trades where school ties are indicated. Perhaps you can capture the 20% return indicated in the study!

Mutual fund managers invest more money in companies that are run by people with whom they went to college or graduate school than in companies where they have no such connections, the study found. The investments involving school ties, on average, also do significantly better than other investments.

...“Something about these social networks is allowing portfolio managers to better predict the future returns of companies within the network,” said Lauren Cohen of Yale, another author.

The study looked only at mutual funds, which are required to report their holdings and performance regularly. It did not examine hedge funds, which are investment pools for wealthy individuals and institutions; hedge funds do not have to disclose their holdings publicly.

...Their study, titled “The Small World of Investing,” examined 85 percent of the total assets under management from 1990 to 2006 and looked at different levels of university connections.

In the weakest kind of connection, a fund manager and one of a company’s top three executives shared nothing more than an alma mater. They could have attended different schools within the university and have been on the campus decades apart.

In the strongest connection, a fund manager and one of the top three executives attended the same school at the same university, and their time on campus overlapped. The most common shared school in the study, by far, was Harvard Business School.

On average, investments in companies where there was no connection returned 11.7 percent a year before fees, according to the economists’ estimates. Investments in companies with the closest level of connection — when a fund manager attended school with an executive — returned 20.1 percent a year.

As might be expected, investments with weaker connections had returns that fell somewhere in between, with returns of more than 11.7 percent and less than 20.1 percent.

The most benign explanation for the pattern is simply that fund managers who attended school with executives have an easier time learning about the companies where those executives work. They are more likely to travel in similar social circles and may even remember their old classmate’s strengths and weaknesses.

“The results are much more consistent with the story that you went to college with Person X and know they’re really smart,” said Steven N. Kaplan, a finance professor at the University of Chicago. “My guess is that the whispering is going on, too, but the question is the relative amounts.”

Supporting Mr. Kaplan’s view, the paper does not offer clear evidence that the investments by the fund managers did unusually well in the weeks and months immediately after a stock was purchased.

On the other hand, investing based on school ties seems to have become less popular recently, which could suggest that financial regulations passed after the demise of Enron cut down on the exchange of inside information.

Last year, 7.1 percent of fund managers invested in at least one company that had a top executive with whom they had gone to school, down from 15 percent in 2002. The average during the 1990s was 11 percent.

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