Sunday, February 22, 2009

In defense of mutual fund managers

Last week there was a flurry of posts in the blogosphere about how dumb mutual fund managers are. Michael Stokes of MarketSci kicked off the discussion with I Just Don’t Get It (the Failure of Mutual Funds to Think Outside the Box). It was followed by other supportive posts such as the one by Damian at Skill Analytics.

I would like to address the very real points raised by these bloggers. Most of the complaints fall into two categories. The main one goes something like this: “I’ve got a great system, why can’t Wall Street recognize me?” In both these cases, the writers identify themselves as “quants” and blame the bottom-up fundamental stock picking mindset as mental barriers to superior mutual fund performance.

The second complaint is voiced more indirectly. If there are great quantitative systems or thinkers around, why can’t the average mutual fund outperform?


Would you go to a pizza joint for sushi?
There are a number of misconceptions at work here. These writers fail to understand that asset management is a business. More importantly, they fail to understand what mutual fund managers are selling.

Investors use mutual funds as building blocks in their portfolios. Allocate 60% to stocks, 40% to bonds. Within the stock portfolio, allocate this much to large caps, that much to small caps. Maybe if you have a great growth manager, then offset it with a value manager, etc.

Style drift is death to mutual fund marketing. Investors don’t like surprises. If you bought a fund that was labeled as a mid-term government bond fund, what would your reaction be if you found it stuffed full of emerging market bonds? What is the mutual fund manager’s business risk if the emerging markets blew up?

Do you go to a pizza restaurant and order sushi? Mutual fund managers are acting rationally. They are delivering what their customer wants. Straying from their mandate is the equivalent of offering sushi at a pizza joint. While bloggers such as Stokes, who work mainly on market timing models, have some very interesting ideas. Unfortunately for him, many of their ideas don’t fit in the mutual fund “boxes”.


He’s just not that into you
There is admittedly a cultural divide between fundamental stock pickers and quants. I have experienced that all my professional life. The job interview described by Damian, a quant, by a fundamental stock picker was an example of that divide.

Accept it. He’s just that into you.

I would take exception, however, to some of the points raised in his post.

Reliance on a single approach: Not all fund managers are fundamental stock pickers. There are many quant firms out there. One example of prominent name who has been in the news a lot recently is Jeremy Grantham of GMO.

Strategy Scaling Requirement: Damian admits that “many of the quantitative strategies that people put forward on the net (including my own) simply won’t scale to the size of a $1b fund.” If a strategy isn’t very scalable, isn’t its commercial value limited?

Fully invested: See my previous comment about ordering sushi at pizza joints. Mutual funds are there to provide an investor exposure to an asset class. Unless you style yourself as a market timing fund or an absolute value fund, then not being fully invested all the time is style drift.

100 stocks or more = Indexing: As a quant, he should know better than that. If I were to hold an equal weighted portfolio of the top 100 stocks in the S&P 500, the forecast tracking error, according to most risk models, would easily be in the 3-5% range. (Note that tracking error is defined as the forecast one-standard deviation return difference between a portfolio and its benchmark).


If you're so smart, start a hedge fund
I have also done a lot of interesting work as a quant during my life. You can find some examples here and here – and they only scratch the surface of my thinking. Most notably, some of my models didn’t blow up in August 2007 when many equity quant funds melted down, indicating a crowded trade. I recognize that in many cases, the chemistry just isn’t right.

If people who complain about mutual funds believe that they have a real alpha, then the answer is simple: go start a hedge fund! Hedge funds are supposed to be the embodiment of pure alpha.

Oops! We know how that turned out for a lot of people.

In reality, there is a lot more to portfolio management that knowing what to buy and sell. The case of Peter Schiff is a recent example but he is not alone. That’s why I am working on my book project.

Amateurs pick stocks, sectors, markets, time markets, etc. Professionals manage portfolios.

7 comments:

Otto Rock said...

Amateurs pick stocks, sectors, markets, time markets, etc. Professionals manage portfolios, go belly-up and get bailed out.

Seems to me that the stigma of the word "amateur" and the social cachet of the word "professional" whould be reversed when it comes to this subject.

keithpiccirillo said...

This article was pretty objective and provided a good, all encompassing viewpoint.
I especially like how you blended in the links from previous posts to corroborate your positions.
Thank you.

tom brakke said...

Good posting. You are right that investment management firms exist to provide what "the market" will buy. For the most part, advisors and do-it-yourselfers have bought into the notion that managers should be judged by relative performance, so that's what the firms attempt to provide, and therefore what the portfolio managers attempt to provide.

It all leads to lots of behavioral errors and portfolio managers that are forced into playing a game that is detrimental. They become actively unconnected from the true needs of investors.

Damian said...

Interesting comments - here's some comments on it:

"The main one goes something like this: “I’ve got a great system, why can’t Wall Street recognize me?"

I think you've missed the point - I don't think I should be recognized by Wall Street for my strategies - my point is that the insular world of the mutual fund business is in dire need of a shake up because they have not provided value.

"There are a number of misconceptions at work here. These writers fail to understand that asset management is a business. More importantly, they fail to understand what mutual fund managers are selling."

No - I don't misunderstand this - my point is that investors tend to be rather uninformed - therefore there is no burning platform for them to change. If it was a business in an active market place in the purest sense, under performing funds would get weeded out - which they don't - as the small cap fund I interviewed with showed. Here was a fund that had underperformed for years and had an incredibly high cost - yet it continued to exist.

As for the issue of style drift - I'm not arguing that they should drift - but rather that they should be concerned that their style doesn't work vs. a passive indexing approach. A tech-orient fund shouldn't change their style, but they should be able to beat, repeatedly, a passive approach of, say, buying XLK. If you can't do that on a consistent basis, then your fund is just an expensive and underperforming tech fund.

"Do you go to a pizza restaurant and order sushi? Mutual fund managers are acting rationally. They are delivering what their customer wants."

Well, the customer, then, isn't very smart. Paying a huge amount for under performance is pretty stupid.

"Accept it. He’s just that into you."

I think you blew your own joke - "He's just NOT that into you" but whatever - you're right - he wasn't - see comments on small gene pool.

"Reliance on a single approach: Not all fund managers are fundamental stock pickers."

Of course not - I never said they were - but the vast majority - I would say 10-1 - are fundamentally oriented. The small cap fund I interviewed with had a quantitative component to their strategy - it just didn't work.

"If a strategy isn’t very scalable, isn’t its commercial value limited?"

Yes - that's my point about us smaller quant guys - mainly that that is the opportunity. But what that points to is this: passive indexing is just a much, much better way to go.

"Unless you style yourself as a market timing fund or an absolute value fund, then not being fully invested all the time is style drift."

Agreed on this point.

"If I were to hold an equal weighted portfolio of the top 100 stocks in the S&P 500, the forecast tracking error, according to most risk models, would easily be in the 3-5% range."

Yes - my point is just this - as the number of stocks goes up, you're an index. The bigger your fund, the more stocks it likely needs to hold, the more it approaches an index.

"If people who complain about mutual funds believe that they have a real alpha, then the answer is simple: go start a hedge fund! Hedge funds are supposed to be the embodiment of pure alpha."

Well, I did start a hedge fund. However, part of the point of my piece is the small gene pool issue. You won't be able to get money if you do not come from the right background as determined by the Wall Street crowd. There are cases of people putting together funds without that background, but they are few and far in between.

And as for hedge funds delivering pure alpha - most, in my experience, simply deliver beta plus leverage. And we saw how well these absolute return strategies have done in the past year. Not much alpha out there.

Again, though, I'm talking about the lack of value that mutual funds bring, not the value a hedge fund brings.

"Amateurs pick stocks, sectors, markets, time markets, etc. Professionals manage portfolios."

This comment really made me laugh - you should tell that Jim Simons - he seems to be really down on his luck timing the market. That's not to say that he is not managing a portfolio. And it is not to say that I'm not managing a portfolio via different strategies. They are not mutually exclusive.

Overall, I think this comment shows your bias - you're part of the Wall Street crowd and hold these professionals in high-esteem - despite the fact that they don't, by any analytical analysis, deserve much of it.

The issue you haven't addressed in your post is why anyone would pay a large expensive fee for a mutual fund when 70-75% of them under perform any basic indexing strategy. As such, you are right - they are a business - just not one that is orient toward actually serving their customers. Instead, they are oriented around gathering the largest amount of assets possible.

For me, the question of why mutual funds don't look at outside-the-box ideas simply comes down to the lack of a burning platform. This creates opportunities for someone like Simons by leaving a huge pool of talent at his disposal.

So the question is this: when will the mutual fund managers, if ever, face a burning platform that forces them to actually perform or get out of the way?

Thanks for the critique - I do appreciate the time and energy you put into the post. And I really do enjoy your blog and will be adding it to my blogroll.

Arthur said...
This comment has been removed by a blog administrator.
Kieran said...

John Mauldin once said that if you can produce 20% returns for five years, and you can prove that you did, you won't have to go find the money, because it will find you.

I think that's true.

I agree that most mutual fund managers underperform, but they are the excellent foil for your work, if you're good. I agree that there's huge hurdles to entry for the little guy, but if you work hard and you persevere you can make it.

Trader Kevin said...

Damian: "My point is that the insular world of the mutual fund business is in dire need of a shake up because they have not provided value."

Noooo!!! We need mutual fund lemmings to drive the markets too high or too low so we can fade them profitably!

I'm ecstatic to live in a world where being down 33% during a year when the benchmark is down 36% makes one a star!