Why MFs Ride the Failboat -- A response to MarketSci
This morning Mike at MarketSci pondered why mutual fund managers just can't seem to get it right, yet he can (he has an audited track you can check):
"...why the mutual fund industry, with such a low hurdle to clear, doesn’t reach out to folks like me to apply some of our concepts to their more fundamental approach to investing;in other words, why they don’t think outside their little box.
Can anyone honestly tell me that a developer who has produced as much positive consistent alpha as we have couldn’t apply those concepts to a mutual fund and produce that magical and much sought after 1-2% annual outperformance? I think not."
My humble response (please excuse grammar and typographical errors):
Even though I am in what I would call “the brunch” phase of my career (early in the morning, but well awake long enough to clear the sleep from my eye), I have worked in just about every facet of asset management, and I am consistently befuddled by the poor performance of professional money managers. That said, I posit a few ponderables about WHY they are so bad:
1) Incentives/Risk Aversion: as you know, most money managers are really asset gatherers, skimming their fees off the top of AUM, not performance. Unfortunately this leads to an asymmetric risk aversion model of money management. Rightly or wrongly people benchmark their manager’s performance against a well known benchmark (simple framing heuristic). Since I am sure you are familiar with the risk-aversion “S” curve I won’t get into the details, but suffice it to say the visceral reaction an investor (client) has to underperformance is far more pointed than their reaction to outperforming the benchmark. Money flows more swiftly out of funds that underperform by, say, 200bps, than it flows in for 200bps of outperformance. Gathering assets takes time; losing them doesn’t. Since there is little payoff for marginal outperformance (zero profit participation), and a heavy penalty for marginal underperformance, PMs manage towards an alpha of zero (after fees): hug the benchmark and your career is safe. Furthermore, a single drawdown of any magnitude is likely to stain ones reputation for years, whereas (again) a single positive year is likely seen as “lucky” or flash in the pan. (This is nothing new, but it’s still true).
2) Regulations: while there are some (albeit a minuscule number) of actively managed funds that actually manage concentrated or unique strategies, the majority of funds are boxed in by diversification rules, bans against shorting, etc. As you know, the greater diversity assets you hold the closer you are going to perform “as the market” (for the few novices in the crowd just look at the Dow and SPX correlations…they are incredibly high even though the two indices have different methodologies, weightings, sector exposures, etc) in fact, if i recall correctly, after about thirty stocks you are at a .8-.9 correlation and beta to the market. Today it is (near) impossible to run a portfolio that DOESNT act like the funds respective “market”, simply because of the forced diversification.
It is also incredibly difficult to change ones investment/trading strategy in a fund that requires are the requisit fillings, risk analysis, and BoD approval. Therefore it’s tough to be agile and “try new things”.
3) Assets kill performance: on top perverse misalignment of incentives “asset gathering” promotes, the game of “getting big and collecting fees” is antithetical to efficient investing. A) As you grow in size your trading agility decreases as your ideal position sizes are corrupted by a major exogenistic (non investment) factor: moving the market. The elasticity of prices with respect to liquidity severely hinders a funds actual investment universe and forces PMs down their “best ideas curve”. B) Since there are “upper bounds” in how much you can invest in any one stock (by virtue of point “A”) you are forced to go down your investment prospects list to simply have somewhere to park excess cash. PMs aren’t paid for holding cash (it’s seen as the client’s role to measure their risk tolerance and balance accordingly), and the presence of cash reserves may (rightly or wrongly) signal that the PM is out of ideas (a negative signal).
4) Client representatives/Buyside advisors: these geniuses love to take complex situations and boil them down to nothing more than a series of comps from traditional style-box analysis. If you can’t be bucketed into a well defined style pension/insurance/RIA advisers won’t even look at you. God forbid they have to take the time to understand products and explain a complex subject to their clients. Rather they prefer to simply have a matrix by which they can punch in return streams and holdings then say “XYZ is best, look at their Sharpe!” When I launched one of those fabled HF Replication products the toughest hurdle to clear was figuring out how to “box” the fund–not the mechanics, not the methodology, they only asked “what box would this go in?”
5)Finally, to sum everything up, MF companies are big, slow moving organizations. On top of the regulatory hurdles most funds are seen not as alpha generators, but as product shelf fillers. A “good” mutual fund shop has a product for every “box” and they need to keep their presence in each category regardless of performance or rationality. If a PM on, say, a large cap value fund underperforms heavily then the PM is simply replaced because every platform needs a LCV fund. To the contrary, should you outperform your market, but exhibit any kind of style drift, you can just as easily be canned because people will complain “they dont know what they’re buying”. And god help you if you come up with a new investing metric to base your analysis on—you’ll have to prove it works to your handy dandy risk department for well over 6 months, but which time it’s probably arbed out anyways.
At the end of the day it’s the structure of the system that has set portfolio managers up to fail–all in the name of “protecting” retail investors. The only places you see demonstrable alpha is in the HF community because they can trade nimbly, react quickly, generally aren’t big enough to move markets, and have an aligned incentive structure. Is it perfect? No! But you are never going to eliminate all principal-agent problems, which is what this REALLY comes down to. HFs are just allowed to act as better agents.