New study of mutual fund alpha shows that what-goes-around-comes-around

CAPM / Alpha Theory 27 Jan 2010

goingaroundFor year, researchers have been telling us that one of the biggest determinants of mutual fund alpha (or lack thereof) is a fund’s expense ratio.  What little raw alpha is generated, the argument goes, is eaten up by management fees.

On the surface, a new study of “the dynamics of average mutual fund alphas” seems to suggest the same thing.  But under the surface, the paper makes an interesting observation about the changing structure of markets themselves.

The paper is by Diana Budiono, Martin Martens, and Marno Verbeek of Erasmus University in the Netherlands.  The trio says that many studies have explored mutual fund alpha itself, but most,

“…focus on the average alpha, (and) few say anything about how average alphas change over time, and what drives average alphas.”

In a bit of an anti-climax, they find that rather pedestrian variables such as portfolio turnover and cost are key determinants of mutual fund alpha over time.  They also find that the ratio of “skilled to unskilled” funds (think ratio of high-tracking error funds to index huggers) determines the level of alpha produced by mutual funds over time.  As any of these variables change, they conclude, so does the average alpha.

In fact, the following chart shows the variables examined by the trio (click to enlarge):


One of the variables examined by the trio is a little different however: the “nonprofessional AUM” ratio.  This is the ratio of equity owned directly by “households and non-profit organizations”.  As you can see, it has been falling steadily since the early 90’s and now sits at around 8%.  Although the study finds that this variable isn’t critical in determining mutual fund alpha, many suggest that the zero-sum game of alpha-generation means someone‘s lunch has to be eaten for mutual funds to produce alpha at all.

At the same time, the researchers find that the ratio of hedge funds to mutual funds has been rising steadily.  You don’t see this in chart because the variable only exists from 1992 to 2006.  Still, the trio writes that,

“…the number of mutual funds and hedge funds has a large explanatory power.”

Curious, we tried to reconstruct this data by comparing the number of hedge funds at the end of each year (according to HFR) to the number of mutual funds (according to the Investment Company Institute).   Here’s what we found:


Both mutual funds and hedge funds grew in number from 1995 to 2000.  But starting at around the year 2000, the ratio of hedge funds to mutual funds started to grow.  The number of hedge funds surpassed the number of mutual funds in the middle of the last decade (the exact year depending on whether you count only single funds or every hedge fund – including funds of funds).

Also beginning around 2000, there was an accelerating drop in the number ratio of “non-professional” money in equity markets.

The study suggests that just as well-paid professional money managers may be able to eat the lunches of “unprofessional” money managers, exorbitantly-paid (hedge fund) professionals may also be able to eat the lunches of the merely highly-paid (mutual fund) professionals.

So it appears as though the mutual fund industry may face pressures from both ends.  After arguing that money management should be left to well-paid professionals, there are fewer DIY players from which to harvest alpha.  But as hedge funds make the same case to investors, mutual funds may find themselves in the same, somewhat awkward position as the lunch-server, not the lunch-eater.

A cynic might just say, “What goes around comes around”.  Thankfully, though, we’re not cynics.

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One Comment

  1. Tom Brakke
    January 29, 2010 at 12:11 pm

    This phrase jumped out at me: “They also find that the ratio of ‘skilled to unskilled’ funds (think ratio of high-tracking error funds to index huggers) . . .”

    I’ve been watching this as it relates to the marketing of products. The “tracking error is bad” theme is still pretty entrenched overall at the advisor level (and for “unsophisticated” clients), but it pops up in a lot of ways and places that you wouldn’t expect even among “sophisticated” clients.

    It will be interesting to see whether that philosophy changes over time across the business, and whether instead of using a screen that includes a maximum on tracking error people will start with a notion of a minimum threshold below which it’s not worth looking.

    Tom Brakke

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