Implications for Advisors

Mark Hulbert posed the question of why skill declined over the 32 year period, and offered three possibilities:  high fees and expenses, increased market efficiency, and the movement of skilled mutual fund managers to the hedge fund industry. 

The study showed that over their entire histories, 9.6% of funds produced truly positive alphas before expenses, while almost none produced significantly positive alphas after expenses.  This indicated to the authors that, even though expenses for actively managed funds declined over the period studied, expenses eliminated the good performance of a lot of managers who appeared to have true stock picking skills.   Given that only 0.6% of funds produced alpha over this period, skills are dropping faster than expenses.   Wermers said that “expenses are too high, relative to the ability of fund managers to generate alphas. “  He added that a “prescription is to pay close attention to the expenses charged by funds, as higher expenses do not seem to be associated with higher skills.”  We concur, as does the overwhelming body of academic studies on mutual fund expenses.

Regarding the possibility that the market has become more efficient over this period, Wermers noted that several recent studies have shown this to be true.  The FDR test has not yet been applied to hedge fund or separately managed account databases.  If it did, and it revealed a similar decay in skill, that would support the hypothesis that the market has become more efficient.

We believe the fundamental reason for the decline in skill is the movement of skilled managers to the hedge funds, and this factor overwhelms any other possible explanation.  The hedge fund industry is the most profitable industry ever conceived, and its performance-based fees insure that skilled managers will be handsomely compensated.  By contrast, very few mutual funds utilize performance-based fees.  The asset-based fees in the mutual fund industry will naturally select for those managers who cannot succeed in the hedge fund industry.

One aspect of the fund’s methodology troubled us.  We believe a more meaningful question to ask is whether fund managers possess skill, not whether the fund possesses skill.  This could be answered by applying the FDR test at the manager level, not the fund level.  Wermers noted that the referees from the Journal of Finance who reviewed the study raised the same issue, and he plans to add these findings once he completes the analysis.

The final question is whether the study proves that it is “almost hopeless” to find skilled active managers, as Mark Hulbert notes in his article.  Wermers thinks not.  He said “there is a role for smart sophisticated advisors to make a difference, because it is so hard to find a skilled active manager.”  He added that advisors should also be prepared to say when it is appropriate for clients to go passive.  “Advisors add value by looking at management, strategies, track records, expenses, and all other factors to determine whether skilled managers really work hard to find good active alpha,” he said.

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