One of the most important principles of economics is that agents earn economic rents if, and only if, they have a competitive advantage that's in short supply. Given the overwhelming body of evidence on the inability of active managers to generate persistent alpha - be it in mutual funds or hedge funds - when we think about which is the scarce resource, investor capital or the ability to generate alpha, the obvious answer should be the ability to generate alpha, or manager skill. Which raises the interesting question: Given the large fees charged by actively managed funds, do mutual funds earn economic rents without possessing skill? Jonathan B. Berk and Jules H. van Binsbergen, authors of the study "Measuring Skill in the Mutual Fund Industry," sought to answer that question.
Using the CRSP survivorship bias free database of mutual fund data, their data set spans the period from January 1962 to March 2011. The study included all U.S. funds, including those that invest in international stocks. Returns were compared to both risk-adjusted benchmarks as well as to Vanguard's index funds (an easily investable alternative). The following is a summary of their findings:
- The average mutual fund has added value by extracting about $2 million a year from financial markets.
- Value added is persistent for as long as 10 years.
The authors concluded that it's hard to reconcile their findings with anything other than the existence of money management skill.
While the finding of manager skill may seem new, it's actually consistent with the findings of prior studies which used gross returns to show that managers have skill in picking stocks.
Given the evidence of skill, the question remains as to who benefits from the skill? That is, do mutual fund companies and managers capture all the rents, or are these rents shared with investors? Unfortunately for investors, the average net alpha across all funds wasn't significantly different from zero. For domestic stocks only, the value weighted net alpha was -5 basis points per month compared to the Vanguard benchmarks, and -8 basis points per month compared to the risk-adjusted benchmarks. For all stocks, the figures were slightly better, -1 basis points per month versus the Vanguard benchmarks and -6 basis points per month versus the risk-adjusted benchmarks. (table p.46) Thus, there's no evidence that investors share in the fruits of manager skill. In other words, just as economic theory predicts, the economic rent went to the scarce resource.
However, it is important to remember that the net alpha doesn't determine whether managers have skill or not. In fact, it was in a 2004 paper, co-authored by Jonathan Berk and Richard C. Green, "Mutual Fund Flows and Performance in Rational Markets", that explains: "If skill is in short supply, the net alpha is determined in equilibrium by competition between investors, and not by the skill of managers."
None of this is new. There have been other papers that found that before expenses, the stocks actively managed funds buy outperform risk-adjusted benchmarks. However, after expenses the alpha turns negative. For example, the study "Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transactions Costs, and Expenses," by Russ Wermers, published in the August 2000 issue of the Journal of Finance, took an extensive look at the stock selection skills of active fund managers and found that on a risk-adjusted basis the stocks active managers selected outperformed their benchmark by 0.7 percent per annum. However, expenses more than eroded the benefits from stock-selection skills, leaving investors with net negative alphas. In other words, the economic rent goes to the scarce resource (the ability to generate alpha), not to the plentiful resource (investor capital) - just as economic theory predicts.