Sunday, March 02, 2008

The Economist on Fund Managers

The Economist weighs in on managed funds and market efficiency this week, and is generally scathing about the fees charged by fund managers to (on average) fail to meet the market return. (Their editorial's subhead is particularly blunt: "Investors pay too much to have their money managed.") They point out that from 1980 to 2005, the S&P 500 index produced an average annual return of 12.3%. In the same period, the average equity mutual fund returned 10% a year. But the psychology of investors is revealed in the figure of returns for investors of only 7.3% per year. Why do they do worse than the funds? Because investors have what The Economist calls a "regrettable tendency to buy the hottest funds at the top of the market."

This, The Economist says, is the main reason people keep buying mutual funds despite the clear history of general poor performance. They look at past performance of individual funds to make their purchasing decisions, causing them to "buy high," and when that fund goes south (as funds tend to do), they "sell low." The presence of index funds and especially ETFs is slightly denting this. But it leads to some schizophrenia.
A cheap alternative to traditional fund management arose more than 30 years ago, in the form of index-trackers, portfolios that mimic a benchmark such as the S&P 500. Trackers have gained a respectable market share but are much more popular with astute pension funds and insurance companies than with the general public.

Even pension funds entrust money to index-trackers with one hand and to high-charging private-equity and hedge-fund managers with the other. They appear to believe both that markets are so efficient that it is hard for fund managers to beat them; and also that markets are so inefficient that it is still possible to beat them after paying hedge-fund managers 2%, plus a fifth of all positive returns.
The way fund managers market themselves, using "alpha," a measure of how much better (or worse) a fund manager does than the market, is brilliant marketing. Alpha is a quasi-scientific way to quantify financial "genius." Apparently when investors look at alpha, the forget such basic principles as the volatility of alpha (alpha does not remain constant), that survivorship bias makes average alpha appear higher than it actually is, or the simple idea of reversion to the mean.

Whenever I make these arguments, I get: "Yeah, but what about WarrenBuffettGeorgeSorosPeterLynchetc.etc.etc.?" I love a compelling individual story as much as the next guy, but such a story tells us next to nothing about general conditions.



Anonymous Anonymous said...

Do you think that the super rich are investing in retail mutual funds or in index funds? Or, do you think that the super rich utilize hedge funds? And why?

12:24 PM  
Blogger  Robert Boyd said...

That's the question. I don't understand why--it doesn't seem rational in the face of the returns they can expect versus the huge fees they have to pay.

My only guess is that having money makes you feel you can gamble. So you are willing to gamble and, on average, lose on the hopes of getting a large return. After all, some portion of hedge funds (and mutual funds) do outperform the market at any given time. Maybe those investors just believe they are going to be lucky. They are betting on alpha the same way a punter bets on a horse's odds. It seems like mere gambling to me.

That said, I really don't know why. Even The Economist found this behavior puzzling, pointing out that often institutions invested in both index funds and hedge funds simultaneously.

5:12 PM  

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