Advocates for hedge funds often point to performance-based fees as evidence of greater alignment between manager and investor. “We make money when you make money”, they say. However, critics point to the asymmetry of these fees and quip that the hedge fund mantra should be more like: “We’re not happy until you’re not happy.”
In any case, mutual funds, with their asset-based fees, lack such explicit alignment of interests. But advocates for mutual funds will often point out that the link between the interests of investors (returns) and those of the manager (fees) is indirect, but still very real. After all, better performance means more assets will be attracted to the fund and the manager will generate more asset-based revenue.
This makes intuitive sense. But since performance and assets under management are so intertwined, it has always been difficult to disentangle the effects of the two. Does a mutual fund manager aim for high returns for the sake of investors or do they simply to look good and drive asset inflows? (And, at the end of the day, does it really matter?)
An interesting study by Massimo Massa and Yijay Yadav of INSEAD explores one way to determine if a manager really has the best interests of investors in mind (performance above all else) or if they really aim to increase AUM and simply see good performance as a means to that end. What they find may embolden critics of the mutual fund industry.
Massa and Yadav examine the holdings of nearly a thousand mutual funds to determine whether they are biased toward or against “high sentiment” stocks (a.k.a. “stock market darlings”). Previous research has shown that these stocks don’t perform that well over the long run. As they explain:
“…being consistently loaded on low-sentiment stocks does generate a superior performance as it greatly overperforms during periods of high-market sentiment and does not differ drastically during periods of low market sentiment.”
As they later point out, this axiom is a close cousin of the value premia. In fact, the creator of the “sentiment” index (see paper), Jeffrey Wurgler of NYU, used various proxies of sentiment that would seem to favor growth stocks: the closed-end fund discount, NYSE share turnover, first-day returns on IPOs, new issues, and the dividend premium. The problem for these growth stocks is that these conditions only last for a few years at a time (see chart below from Wurgler’s original paper):
So knowing that mutual fund managers are small people who read the latest academic research, Massa and Yadav wondered if they take advantage of this market anomaly? In other words, do they buy out of favour “low sentiment stocks” in an effort to increase returns.
Curiously, they found that mutual funds actually did not but such stocks. Instead, they bought the destined-to-under-perform stock market darlings. And they found that mutual funds that were part of large complexes, tended to be less active, and ignored analysts reports tended to have a higher “fund sentiment loading.”
You’d think the lower expected returns from these stocks would eventually come back to haunt them, right? After all, mutual fund investors are notorious performance chasers. And when performance suffered, assets would flow out of the fund.
This is where things get weird. It turns out that investors love funds that load up on “high sentiment stocks”, despite their lower performance. Write the duo:
“…a fund that is loaded on high sentiment stocks at the very moment in which the market displays a high degree of sentiment is more likely to capture investor attention.”
And amazingly, the asset inflows to be gained from loading up on high sentiment stocks “more than offsets the loss of flows due to poor performance…”
They find that a 2 standard deviation increase in “fund sentiment loading” increases monthly asset inflows by 21% per annum – even more than the asset inflows they can expect by moving from the bottom 20% of funds to the top 20%.
In other words, the decision to load up on these investor favorites may be affected by marketing and asset raising issues, not just an (ill-advised) quest for performance.
The authors are far less charitable…
“…funds deliberately sacrifice performance in order to have a portfolio composition that attracts investors…Our findings provide a first direct evidence of the existence of a trade-off between performance and marketing in the asset management industry and first evidence on how the industry prefers the latter to the former.”
So is this strategy as nefarious as it sounds? Or is it simply a by-product of mutual funds’ need to stick with the pack and hug a benchmark? It would be interesting to see if these findings would apply to hedge funds with their explicit goal of finding off-the-wall investment ideas and the lack of public information on their holdings.