We’ve talked a bit before about how there’s a booming academic business in papers finding that investment managers do or do not add value versus non-managed alternatives like passive indexing or keeping your money under your pillow and just burning a constant percentage of it every month. Part of why that’s a thing is that the data can be prodded, smooshed, or cherry-picked to say many different things, and so they are. I enjoyed this paper about mutual funds by Stanford GSB profs Jonathan Berk and Jules Van Binsbergen (NBER today here, SSRN in April here) in part for its discussion of data problems, which starts with the fact that they used the industry-standard (in the academic-papers-about-mutual-funds industry) CRSP database and compared it to Morningstar data because “even a casual perusal of the returns on CRSP is enough to reveal that some of the reported returns are suspect.” Suspect like:
We then compared the returns reported on CRSP to what was reported on Morningstar. Somewhat surprisingly, 3.3% of return observations differed. Even if we restrict attention to returns that differ by more than 10 b.p., 1.3% of the data is inconsistent. An example of this is when a 10% return is accidentally reported as “10.0” instead of “0.10”.
That is one way to get alpha. Anyway they look at the data using a (strangely) unusual metric of dollar value added, which is roughly alpha (gross excess return over some investable benchmark, in this case a Vanguard index fund) and multiplying it by assets under management, the intuition being that making 1% excess return on a $10bn portfolio is more impressive than doubling your $10 bet at the craps table. And they find that mutual fund managers are better than controlled money burning by the thinnest of margins:
The average manager adds an economically significant $140,000 per month (in Y2000 dollars). The standard error of this average is just $30,000, implying at t-statistic of 4.57. There is also large variation across funds. The least skilled manager amongst the top 1% of managers generated $7.82 million per month. Even the least skilled manager amongst the top 10% of managers generated $750,000 a month on average. The median manager lost an average of $20,000/month and only 43% of managers had positive estimated value added. In summary, most funds destroyed value but because most of the capital is controlled by skilled managers, on average, active mutual funds added value.
So their headline is that the average (not median!) mutual fund manager has a skill worth about $2mm a year, and the analysis in the text suggests (1) that this skill persists over some longer time period and is a real thing rather than coin-flip success and (2) that investors recognize this skill and reward it by essentially putting more money with better managers which allows them to make their skills bigger or something.
Two things I like here. One is the notion of measuring investor skill in dollars rather than percentages. This does not entirely work, in that there’s a self-fulfillingness to “investors recognize skill by giving more money to skilled managers who therefore get more skill points for the same percentage return,” but it’s a nice way to recognize the fact that the more money you have the harder it is to obtain alpha. They are not the first people to recognize a Peter principle of good managers getting too much money and having their size become a drag on performance, but I like the metaphor of managers having a fixed dollar amount of skill and spreading it over more and more investors as their skill is recognized.*
The second thing I like is that if you think that the skill of managing money for others is, for most managers, not that scalable and worth on average something in the low single digits of millions of dollars, then you might look to develop skills that are more scalable and that the market is more likely to reward. Take for instance a guy like Ezra Merkin:
Money manager Ezra Merkin has agreed to pay $410 million to settle a lawsuit brought by the New York attorney general that accused Merkin of steering client money to Ponzi schemer Bernard Madoff, a person familiar with the settlement said on Sunday. … The New York lawsuit, brought in 2009 by Andrew Cuomo, the attorney general at the time, said Merkin “recklessly” fed money from investors in his funds into Madoff’s Ponzi scheme, while claiming he actively managed their money.
Merkin held himself out as an “investing guru” and collected more than $470 million in management and other fees while he was really a “master marketer,” the lawsuit said.
Well, of course. Being an investing guru is hard and of limited value – even if he’d been a top 10% mutual fund manager, Merkin’s investing prowess would only be worth about $9mm a year, some of which he’d presumably have to give back to his investors. But holding yourself out as an investing guru is evidently more profitable, since in his ~20 years of surreptitiously funneling money into a Ponzi scheme Merkin managed to make $470mm in fees. Also he didn’t have to do any investing! This is a much better business model, especially with a few tweaks like trying not to invest in Ponzi schemes, and is in fact popular in that modified form.
One fairly obvious flaw in the Berk-Van-Binsbergen paper is that it tries to find investing skill among mutual fund managers. But mutual funds seem like a bit of a relic: sophisticated/rich investors are replacing them with ETFs or hedge funds, while smaller retail investors are replacing them with, um, ETFs or poverty. There are many reasons for this shift but one may be that mutual funds, as transparent vehicles that have clear investing limits and that can easily be benchmarked against passive strategies, provide rather limited room not only for investing skill but also for marketing skill: Ezra Merkin could not have cashed in on his dazzling Ponzi-funneling abilities if he’d worked at a public ’40 Act mutual fund. The smart people are going where they can be rewarded, either for investing audacity (“bet the whole fund on index CDS? sure!“) or fee audacity (“charge 5 and 50? sure!“) or just fraud audacity. If you’ve got really valuable skills, you might as well get paid for them.
Measuring Managerial Skill in the Mutual Fund Industry [NBER, free SSRN here]
Merkin settles Madoff-related suit with New York [Reuters]
* Also getting paid most of it – the paper measures skill based on gross returns, but also shows that fee income does rise with skill; good managers clip more fees than bad ones, so they outperform less on net than on gross value added.