We’ve covered a lot of developments in the so-called “hedge fund replication” field. But switching gears now, we’d like to look at what amounts to “mutual fund replication”. Sure, hedge funds aim to provide a high proportion of alpha in their returns, but hedge funds don’t have a monopoly on alpha. In fact, as the chart in Friday’s posting clearly illustrates, many mutual funds actually have a lower correlation to traditional asset classes than do mutual funds (and therefore a higher proportion of potentially “replicatable” alpha in their returns than many hedge funds).
Conversely, that chart also shows that many hedge funds have a remarkably high correlation to traditional asset classes – suggesting that a relatively small proportion of those returns are alpha. At the end of the day, hedge funds and mutual funds are in the same game – finding new sources of returns before those returns are “replicated” by ETFs, liquid derivatives, or “hedge fund replicators”. In other words, it’s not about “hedge” vs. “mutual”. It’s all about active management.
This recently released paper from The Cass Business School in London clearly illustrates these blurred line between hedge funds and mutual funds:
“Large sections of the mutual fund industry follow active strategies and more recently there is an ongoing debate on whether mutual (and pension) funds should invest in hedge funds and private equity, which also follow a wide variety of active strategies. The question is therefore whether ex ante, one can find actively managed funds (after correcting for risk and transactions costs) which outperform index funds and whether investors switch funds out of â€˜loser fund’ into â€˜winners’.”
This paper concludes that very few mutual funds produce adequate alpha to overcome their fees. While fellow Cass professor Harry Kat argues only 20% of hedge funds produce enough alpha to make them worthwhile, these researchers conclude that only 2-5% of mutual funds “genuinely out-perform their benchmarks”.
The authors review dozens of previous studies containing several theoretical industry models. One particular model may appear to mutual fund cynics as being an accurate description of the mutual fund industry’s modus operandi:
“Essentially, skilled managers pursue an active strategy until the expected net return on the marginal dollar (of) inflow equals the return on a passive index fund â€“ after which any additional cash inflow is placed in index funds…The manager faces increasing marginal costs on actively managed funds which establishes an optimal size for managed funds with any excess invested in the passive fund (at zero cost). As additional fees are paid on index funds, this is how the active managers extract their rents.”
After walking through dozens of mutual fund studies over the ensuing 70+ pages, the authors conclude:
“Overall, academic work demonstrates that there are relatively few mutual funds which have genuinely positive alphas and picking ex-ante winners is very difficult…In contrast, persistence among past loser funds is well established. The evidence on fund performance suggests that any â€˜national’ savings schemes (e.g. 401K schemes…) should warn against trying to â€˜pick winners’ and seek to provide impartial, independent information on fund performance. Sensible advice for most investors would be to hold low cost index funds and avoid holding past â€˜active’ loser funds…current evidence suggests that only very sophisticated investors should pursue an active investment strategy of trying to pick winners – and then with much caution.”
Wow. Hedge funds don’t sound so bad after all. Still, it’s all about alpha. So if your mutual fund produces alpha, then good on ya.
Note to mutual fund managers: AllAboutAlpha is an equal-opportunity skeptic. So stay tuned tomorrow for a hum-dinger of a paper showing how hedge funds are no better than mutual funds.