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.

Comments

[Anal_yst]

The ol' "Lake Woebegone" syndrome, so-to-speak, can't be ignored either, but I think that's probably either a sub- or super-set of your above points.

[Kid Dynamite]

ah yes... but if there's anything we should have learned over the last 18 months it's that the hedge fund boys generate a lot less alpha than we thought...

and i certainly wouldn't support a hedge fund (performance based) comp model for mutual funds.

[thoth]

I think most hedge funds exhibit the inverse of these traits, but do so collectively. They are nimble, yes, but mostly in all piling into the same "arbitrage" opportunities (look at the VW short-squeeze). Their incentives may be better aligned with seeking upside, but they aren't as well aligned in protecting against downside. Hedge funds (I know, big generalizatin about to follow) often seek out complex situations that even they might not fully comprehend (CDO B-notes).

I think I remember seeing a stat once that suggested hedge funds are rarely more successful than their first 2 years. Part of it had to do with the rapid growth in AUM that typically followed a successful launch, but I think it also was due to the crowding out by other hedge followers into a previously successful strategy/trade.

That said, I think there is a real need for hedge funds - but maybe more along the lines of the private family vehicles or the Buffet 60's model. Longer-term focus, no real constrictions on strategy beyond risk tolerance, and a healthy sense of perspective.

[ajk]

MarketSci makes a silly and unfair comparison. He is comparing his ONE firm with mutual fund managers as a whole. Any educated investment professional would tell you that, on balance, about half of active managers will outperform their respective benchmark over a given period. The universe of active managers is likely representative of the entire market, which by definition must have an outperformance of 0%.

There are many portfolio managers in the mutual fund space that have proven they are able to outperform over very long time frames. Any one of them could have written the exact same thing. MarketSci is nothing special.

[Joshua Brown]

great piece anal_yst

i wonder, though, will people trade the "possible" returns of edgy hedge funds for the transparency of mutual funds or etfs, even if they are at a natural disadvantage due to the factors you've pointed out?

with each new scam in the alt inv world or hedge/ money manager world, don't you think people, even HNW people, will be driven back to the comfort of the Vanguards they know and trust, regardless of the performance?

plain vanilla may suit the national mood in light of all the trouble that rum raisin and pistachio have caused with the redemption gating and fraudulent statements

no?

[Anal_yst]

@ Josh

"1-2" actually wrote this one, but I'll pass it on, thanks!

[Bulging Bracket]

@ Josh - The people who shouldn't be in hedge funds will be scared back to more vanilla products. There will be a cull of HFs. Leaves room for people who know what they're doing (managers and clients both).

One of the better things for private clients is that institutions will face severe pressure to get out of alternative asset classes. The idiots in the Ivy Alum associations (and on faculty) are doing a very good job of killing their endowments abilities to ever have decent returns in the future, but it means ideas will last longer and individuals will have access to better managers in more accessible sizes (all relative, of course). That it's going to positively screw all sorts of Liberals is just bonus!

[asiequana]

HF better returns? Ha!

I can't count on my fingers and toes how many of my buds are shutting down right now b/c they have no hope of getting back to their HWM.

MFs don't do well because investors don't want them too. I.E. - anything that can be called a derivative is a no go, no matter how vanilla. Demand from the big money is squarely in the camp of don't go to far away from the benchmark or we'll cut you off. Where's the incentive to outperform? Closet benchmarking sells.

[Air Jordans]

So funny, I think.*

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