A new study supports the anecdotal evidence.
By John Rekenthaler | 06-16-17 | 06:00 AM | Email Article

Pale Imitations
Oddly, hedge funds thrived during the 1990s and the first half of the Aughts, while “hedge fund-like” mutual fund categories did not. There weren’t many such categories, but those that existed—option-income funds, market-neutral funds, short-term multi-market income funds (don’t ask)—performed poorly. 

John Rekenthaler is Vice President of Research for Morningstar.

It is true that those glowing hedge-fund results came with an asterisk. Because hedge funds are not required to report their returns to a central authority, they self-report. That is, they give their results to databases when and if it suits them. That naturally leads to both creation and survivorship biases, with hedge funds surfacing when the numbers support them, and then disappearing when they do not.

Nonetheless, while academics found the evidence for hedge-fund performances to be mixed, there’s no question that hedge funds outshone those mutual fund categories that emulated them. Many hedge funds, famously, posted outstanding returns during that decade and a half, whereas the list of mutual funds that succeeded by following complex strategies is, to put the matter kindly, scanty.

This paradox is well known. What has not been addressed, until now, is whether mutual funds’ failure was caused by the categories, or by the tactics themselves. That is, did the problem lie with a faultily constructed category, or was the problem more general? Is adding leverage, using options, and/or shorting unhelpful for most mutual funds, regardless of their investment category?

More is Less?
Per a recent study, it appears to be the latter. In “Use of Leverage, Short Sales, and Options by Mutual Funds,” three faculty members from the Smith School of Business at Queen’s University in Ontario (Paul Calluzzo, Fabio Moneta, and Selim Topaloglu) examine 17 years’ worth of U.S. mutual fund data, and find that, on average, domestic equity funds that use at least one of those three tactics have underperformed their peers.

As you may suspect, some of the shortfall owes to extra cost. The general rule of mutual fund pricing is, the fancier the label, the more that investors pay, and that holds true of the authors’ buckets as well. Those funds that used leverage, short sales, or options at least once during the time period have expense ratios that are 7 basis points (0.07 percentage points) higher than those funds that are permitted such strategies but which abstain, and 19 basis points higher than those funds that are forbidden by prospectus from engaging in such tactics.

(That margin is smaller than I would have guessed, because those funds in the hedge fund-like categories are typically very pricey. The explanation, I think, is that by delving deeply (they examined 101,174 SEC filings!), the authors uncovered many funds that occupy conventional categories—say, large-growth U.S. stock. Those funds use complex strategies to supplement their investment approaches, rather than as their main course.)

Losing by a few basis points because of higher expenses wouldn’t be particularly noble, but it wouldn’t be a disaster, either. The bigger problem is that these funds trail even before costs are considered. The authors compare those funds that use complex strategies to those that are permitted but abstain, and find that usage is correlated with lower returns and higher risk. Neither amount is particularly large (the authors find that using leverage costs 36 basis points per year on average, conducting short sales and buying options costs from 67 to 80 basis points, and that selling options has slight positive benefits), but still, the direction is wrong.

Caveat Emptor
It is at this point that I must issue the usual caveat for mutual fund research that consumes massive amounts of data, and returns summary statistics—the dangers are great! Such studies cannot possibly account for all explanatory factors. To cite the simplest and most perilous of items, the funds’ categories won’t match. Inevitably, some categories will post higher average alphas than other categories, that mismatch affects the results.

(That very issue affected the conclusions of the original Active Share research, which purported to find that funds with high Active Share scores—meaning that they diverged significantly from their benchmarks—had better future performance. It turned out that such funds were also likelier to be from small-company categories, and that small-company categories fared better in the authors’ performance test. So the study contained a hidden small-company effect. In this study, the authors took some additional steps to prevent such an occurrence, but it's tricky to capture all category effects.)

Thus, this article’s headline reads “seems” rather than “is,” and the deck states “supports” rather than “proves.” Despite the authors’ thoroughness, this subject—as the authors themselves would admit—resists a firm, irrevocable conclusion. However, their finding that complex strategies tend to harm rather than help mutual fund performances certainly matches the eye test. The study buttresses the argument that mutual fund managers who invest in flavors other than plain-vanilla have some proving to do. The odds do not look to be in their favor.

Problem Solved
As for the initial puzzle, why complex strategies work for hedge funds but apparently not for mutual funds, I think I can answer that. Complex strategies did boost hedge funds when that industry was small, and they were able to exploit investment niches that rival funds, including the hedge fund-like mutual funds, failed to pursue. Hedge funds were the only game in their small towns, and they profited nicely from that fact. But those days are gone.

As, per the rolling 10-year returns provided by HFRI’s indexes, are hedge funds’ excess returns (see the chart in this Bloomberg article that follows the "Thrill is Gone" heading). There is no mystery to explain, because over the past decade hedge funds have not beaten the mimic mutual funds. True, there remain a few notable exceptions among the hedge funds—managers who do seem to possess an ongoing competitive advantage—but the averages relate a different tale. They reinforce the lesson that mutual fund industry leader Vanguard has long taught its shareholders: Keep it simple, and keep it cheap.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

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