By: Ennis Knupp + Associates
This white paper extends the traditional “fee-erosion” argument against mutual funds to identify the effect of fees on the likelihood of generating a positive alpha. The authors conclude that the chances of an investor receiving a positive alpha are much lower than the chances of a manager actually producing a positive alpha (before fees) and that this disparity in the probablity of a positive alpha grows exponentially with increases in management fees.
But the paper concludes with an even more important observation about the future of the mutual fund, ETF and hedge fund industries…
“The competition [between mutual funds and hedge funds] can be seen as a Hegelian dialectic, advancing from thesis to antithesis to synthesis. The traditional business represents the portfolio management thesis…Hedge funds are the antithesis…Synthesis will bring about adaptations on both sides.
“Some traditional money managers already are focusing on realizing alpha without regard to conventional notions of style; more will follow suit. Some are incorporating long-short techniques or expanded use of derivatives. And lock-ups just might turn up in the traditional discipline in view of the vagaries of arbitrage (the spread on even a good trade can widen before it narrows) and the patience required to invest in less liquid sectors.”
“The synthesis of investment approaches will produce a new generation of institutional investment vehicles. While they will have some key features of hedge funds, these vehicles will have more the feel of conventional institutional investment, particularly in two areas: transparency and pricing. Transparency will present both cultural and reporting challenges for some managers. Pricing, whether fixed or contingent, will have to be plausible, which to me means base fees a small fraction of those of most hedge fund managers.
“Thus, the traditional business faces competition on two sides. On one side, indexing continues to erode traditional manager market share and will exert downward pressure on pricing. On the other, hedge funds have introduced innovations in value-added investing that are difficult to ignore.”