Blog - Investing Notes

Blog Synthesis: Mutual Funds and Hedge Funds

Do investors in mutual funds and hedge funds get their fair share of returns, or are they perpetually disadvantaged by fees and underperforming fund managers? Are there ways to trade around fund flows? Here is a listing of past blog entries related to mutual funds and hedge funds.

The Best Ideas of Mutual Fund Managers ...evidence indicates that equity mutual fund managers can select stocks that deliver economically large risk-adjusted returns, but little of this alpha gets through to fund investors because of alpha-free incentives for fund managers to diversify. Individual investors may want to focus, independently, on stocks that fund managers have newly overweighted.

Mutual Fund Stock Selection vs. General Market Timing? ...mutual fund investors are more likely to find outperformance in funds that emphasize stock selection rather than general market timing.

Morningstar Ratings and Future Returns ...the Morningstar mutual fund rating system can probably help investors avoid funds with the worst future performance.

The Actual Return Experience of Hedge Fund Investors ...actual hedge fund investor return/risk experience, due to the timing of entries and exits, is much worse than that indicated by the continuously measured returns and volatilities of the funds themselves.

The NoLoad FundX Mutual Fund Momentum Approach ...while research generally supports belief in an intermediate-term momentum effect, it is not obvious that the FUNDX mutual fund substantially exploits the effect. Investors may be able to capture more of the effect by applying the NoLoad FundX approach more purely themselves.

The Hedge Fund Size Effect ...large hedge funds contend with significant diseconomies of scale, and consequently underperform comparable small hedge funds.

New Funds Outperform (Again)? ...new mutual funds appear to enjoy initial outperformance by taking on innovative risk.

Hedge Fund Outperformance: Skill or Liquidity Risk? ...hedge fund investors should recognize that many funds generate "alpha" by taking liquidity risks that make converting assets to cash difficult.

Exchange Traded Funds vs. Index Mutual Funds ...ETFs offer easy and unique (even leveraged) access to a wide range of asset class/market/style/sector indexes. The 17% of ETFs that compete directly with index mutual funds perform similarly to, or perhaps slightly better than, those mutual funds.

Outperformance of Distinctive Hedge Fund Strategies? ...hedge fund investors are probably better off with maverick funds, perhaps new ones every couple of years, than with those cut from the herd.

Hedge Fund Performance Persistence ...long/short equity hedge fund investors, if they have the flexibility, may be to able capture future alpha by chasing past alpha.

(Not) Paying for Performance ...mutual fund investors can enhance odds of beating passive benchmarks by focusing on funds with expense ratios that are among the lowest within category.

Pros and Cons of 130/30 Funds ...investors who believe that they can find fund managers who reliably generate alpha should consider the enhanced alpha for higher fee trade-off of 130/30 funds.

Redemption Fees Signal Mutual Fund Outperformance? ...properly structured mutual fund redemption fees tend to protect long-term investors by penalizing frequent traders. Small redemption fees of long duration are optimal for long-term investors.

The Outperformance of (Truly) New Hedge Funds ...hedge funds that are truly new offer investors notable average outperformance for the first couple of years. However, funds that back fill prior performance data when they first start reporting appear to have already "used up" their startup alpha.

Filtering the Luck Out of Mutual Fund Performance Data ...dramatic growth in the number of actively managed mutual funds has driven the proportion of truly skilled funds down, without commensurate reduction in average fund fees and expenses.

The Wall Street Journal's SmartMoney Fund Screen ...the Wall Street Journal's SmartMoney Fund Screen column may have value for picking international and hybrid mutual funds. It is probably not useful for picking domestic equity, sector or fixed income funds, for which strong past performance does not persist after publication.

A Fresh Hedge Fund Horse Every Couple of Years? ...investors may want to get a fresh hedge fund horse every two or three years.

Reliable Outperformance Among Bond Fund Managers? ...past performance is significantly indicative of future performance among bond mutual funds.

Do Hedge Fund Investors Chase or Successfully Time Returns? ...presumably sophisticated hedge fund investors as a group chase past returns and fail to time their investments successfully.

Do Hedge Funds Play the "Famous" Anomalies? ...hedge funds in aggregate exploit a few of the "famous" anomalies, but they apparently have other methods of generating abnormal returns.

Mutual Fund Investors Underperform Their Underperforming Funds? ...mutual fund timers on average underperform passive buy-and-hold mutual fund investors. Investors who use a fund-compensated investment advisor exhibit particularly bad timing.

Stock Picking or Industry Picking? ...actively managed mutual funds on average generate about half their value by picking the right industries rather than the right stocks. This big-picture skill, not company analysis, accounts for fund performance persistence.

Do Funds Focused on Just a Few Stocks Outperform? ...mutual funds with relatively few holdings tend to underperform, refuting the view that focus on a few ideas supports good stock picking.

How Fund Managers React to Success and Failure ...recent success (failure) leads to risk-taking (risk-avoidance) among mutual fund managers.

Measuring the Level and Persistence of Active Fund Management ...fund investors should focus on funds with high "Active Shares" (holdings very different from their benchmark indexes), low assets under management and high last-year returns.

Evaluating Hedge Fund Managers on Walk, Not Talk ...once adjusted for actual (rather than claimed) investing style, recent hedge fund performance is not a reliable indicator of superior manager ability but is a reliable indicator of inferior manager ability.

No Fire Exit at the Overcrowded Hedge Fund Party? ...hedge funds may be more risky than their quantitative strategies indicate because the strategies do not account for the effects of fund growth, proliferation of similar funds and increased leverage. The hedge fund party may have become so crowded that, when someone yells "Fire!", the exit door cannot handle the computer-driven panic.

Characteristics of Persistently Outperforming Hedge Funds ...hedge funds that conservatively smooth out market bumps with minimal net exposure to equities and mid-range returns tend to be the most reliable outperformers.

The Truly Active Part of Active Fund Management ...real active management consists not of the selection of portfolio assets but rather the decisions to change the weights of these assets within the portfolio.

(Low) Volatility as an Indicator of Persistent Hedge Fund Outperformance ...low volatility of returns is key to identifying persistent outperformance among hedge funds.

Hiring and Firing Investment Managers ...the sponsors of retirement/endowment plans show little timing ability in hiring and firing investment managers. There is some evidence that more sophisticated sponsors (of large plans and of plans that invest internationally) make better decisions.

Hedge Fund Stock Picking and Trade Timing ...hedge fund managers seem to be no better at long-equity investing than mutual fund managers; they do not outperform the market.

Rise of the Machines? Attack of the Clones? ...only about 20% of all hedge funds have produced after-fee returns that clearly beat those of statistical replicants that mechanically trade a basket of liquid futures contracts.

Hedge Funds Versus Mutual Funds ...the small positive alpha of hedge funds in aggregate is likely to move toward the negative alpha of the mutual fund industry in the coming years.

The Rareness and Elusiveness of Mutual Fund Outperformance ...this review of mutual fund studies makes low-cost, broad market exchange traded funds sound good.

Follow the Leaders to Capture Short-term Abnormal Returns ...mimicking the most informative actions of outperforming investors/traders reliably generates abnormal short-term returns. Such behavior may explain some of the momentum effect.

Success Factors for Mutual Funds Worldwide ...mutual fund investors venturing into the international arena may want to apply these findings to screen funds according to size, age, fees, management and country.

Paying the Most for the Least? ...high mutual fund fees may signal poor investment returns, both before and after fees. Investors who focus on low-fee funds may enjoy a double payoff.

Automating the "Hedge" in Hedge Funds ...synthetic hedge funds constructed statistically as mechanical trading strategies offer transparent, liquid, scalable, low-cost alternatives to actively managed hedge funds.

Diminishing Returns from Hedge Funds? Or Not? ...it seems that hedge funds overall are not exhausting the supply of alpha offered by other players in worldwide equity markets.

The Timing (In)Ability of Mutual Fund Investors ...mutual fund investors would generally be better off with a buy-and-hold rather than buy-and-sell-and-buy-and-sell investing strategy.

Do Mutual Funds That Practice Behavioral Finance Principles Outperform? ...investing based on the principles of behavioral finance is indistinguishable from value investing, producing similar raw excess returns.

Hedge Fund Success: Timing or Stock Picking? ...equity hedge funds generate alpha by stock picking, not market timing.

Synthetic Hedge Funds? ...relatively simple clones based on exchange-traded instruments perform well enough to be considered as liquid, transparent, scalable and low-cost alternatives to hedge funds for many fund styles.

Better to Have a Fund Manager with an Ownership Stake? ...mutual fund investors should favor funds having ownership stakes, which directly align managerial incentives with investor goals.

Mutual Fund Advertising: Does Harrison Ford Offer a Better Return? ...investors should generally ignore advertising in choosing mutual funds; they should consciously control their fund search methodologies to achieve rational decisions.

A Warm Embrace or Cold Shoulder for Hot Hands? ...even sophisticated hedge fund investors could improve their returns by relying more on homework and less on gurudom.

Indicators of Persistent Fund Manager Outperformance ...persistent outperformance in investing depends on the hard work of developing and applying valuable private information, not on reacting to what everyone else knows.

Hedge Fund Industry: Declining Performance and Increasing Risk? ...hedge fund industry net risk-adjusted returns are unremarkable and declining. The flow of new money to hedge funds may pressure hedge fund managers to take greater risks.

The Morningstar Mutual Fund Rating System Works? ...the Morningstar mutual fund rating system offers value to investors seeking funds for outperformance over the next few years.

Just Protecting Their Investing/Trading Reputation? ...reputational concerns of institutional fund managers may create mispricing opportunities for other investors.

Give Me Your Money Because... ...the advertising of financial firms seeks to tap investor sentiment, a lagging indicator of stock market action, not investor rationality. These appeals encourage trend-following rather than contrarian behavior.

Benchmarking Returns for Hedge Funds ...10% annual return is currently a reasonable hedge fund benchmark.

Mutual Funds Underdiversified? ...most actively managed U.S. equity mutual funds are underdiversified. This analysis seems to argue for buying a broad index fund rather than an actively managed fund.

Outing the (Negative) Alpha ...the active management component of broadly diversified (closet index) mutual funds is generally expensive and ineffective. In comparison, hedge funds with 100% active management are not that pricey.

Dumb Individual Investors and Smart Companies? ...mutual funds may function mostly as passive vehicles through which active individual investors (reallocators) voluntarily transfer wealth to public corporations.

Going with the Flows ...front-running the predictable effects of unusual mutual fund inflows and outflows on stocks held in common offers significant excess returns.

The 5-Star Kiss of Death ...portfolio changes after achieving the Morningstar 5-star rating hurt fund performance, and investors should be cautious about using this rating as the principal means of selecting mutual funds. Handling large cash inflows attracted by the high rating may be the culprit. Or, it may just a change in luck (randomness).

What It Takes to Drive the Big (Hedge Fund) Rigs... ...smart young (hedge fund) drivers wanted.

How's Your Mutual Fund Doing? In case your mutual fund's got you down…

Weighting for Returns ...capitalization-weighted portfolios are inherently underperforming. When evaluating index funds, take the weighting approach into consideration.

Investment Managers Randomly Walking the Plank ...investing in actively managed funds is a loser's game. Professional fund managers cannot systematically find and exploit market inefficiencies.

Smart Mutual Fund Investing? ...mutual fund inflows naively chase past returns.

Follow Institutional Leaders?…individual investors should be wary of investing in stocks that are the top mutual fund holdings.

See also Blog Synthesis: The Wisdom of Analysts, Experts and Gurus and Blog Synthesis: Buybacks and Secondaries for past blog entries that relate to other categories of stock market experts.

In summary, obtaining excess returns from mutual funds and hedge funds is a difficult proposition.