Active Fund Managers Research Articles

How Do Firms Appropriate Value from Employees with Transferable Skills? A Study of the Appropriation Puzzle in Actively Managed Mutual Funds

How do firms benefit from employees with transferable skills? The prevailing view is that labor market frictions that impede employee mobility or strategies that constrain skill transferability are the primary instruments for firms to appropriate value from human capital. The empirical evidence, however, suggests that employees continue to be mobile, and firms pay premiums to attract and retain employees with transferable skills. To reconcile theory with data, we use data from the mutual fund industry, where it is widely documented that active fund managers appropriate more value than they generate. We develop a theory of positive externalities stemming from transferable human capital that we argue accrue mostly to the firm, and provide evidence of such externalities in the mutual fund context. Empirically, we decompose the skills of mutual fund managers into task- and firm-specific components and argue that managers with task-specific skills generate positive externalities at the firm level that are not reflected in their performance measured at the fund level. We advance and test empirical hypotheses on the existence of these positive unmeasured externalities by examining whether managers with task-specific skills are more likely to be associated with activities such as mentoring, increased risk taking, and generating spillovers at the firm level. Our results show that managers with task-specific skills are indeed associated with greater positive externalities, compared with managers with firm-specific skills. We discuss the implications of our results for the literature on human capital value creation and appropriation.The e-companion is available at https://doi.org/10.1287/orsc.2017.1197 .

Actively Managed Funds and Earnings News: Evidence from Trade-Level Data

We use trade-level data to examine the role of actively managed funds (AMFs) in earnings news dissemination. We find AMFs are drawn to, and participate disproportionately more in, earnings announcements (EAs) that include bundled managerial guidance. When the two pieces of news are directionally inconsistent, AMFs trade in the direction of future guidance rather than current earnings. AMFs exhibit an ability to discern, and adapt their trading to, the bias in bundled guidance. While AMF trades at EAs are generally more profitable than their non-EA trades, this result reverses when guidance bias is extreme. Overall, we find increased AMF trading during EAs leads to faster price adjustment. Collectively, these findings suggest AMFs are sophisticated processors of bundled earnings news, and their trading generally improves market price discovery.

All You Need is Passive A Response to Professors Fisch, Hamdani, and Davidoff Solomon

In a recent paper, Professors Jill Fisch, Assaf Hamdani, and Steven Davidoff Solomon argue that passively-managed funds have incentives to engage meaningfully with their portfolio companies because they compete for investors with actively-managed funds. Since passively-managed funds that track indices cannot trade out of the index, Professors Fisch, Hamdani, and Davidoff Solomon argue that passive funds will engage with portfolio companies to increase the companies' stock return performance. In this short response, I highlight four problems with their argument. First, their argument is premised on the assumption that active managers have a comparative advantage over passive funds - the ability to trade in and out of stocks - that passive funds must address, but the empirical evidence - unaddressed in the paper - is that passive investment consistently outperforms active, suggesting there is no such comparative advantage to overcome. Second, the authors ignore a crucial structural problem with their view of passive investment managers: the fund complexes that manage the largest passive funds also sell active management services to some of the largest active managers. This matters because the profitability of actively-managed strategies is an order of magnitude greater than the profitability of the passive strategies. Third, while it costs passive funds little to vote for corporate governance improvements, and while it might be good marketing or relationship-building with their institutional clients, there is no evidence that these improvements give the passive funds any advantage over their active competitors. Finally, but perhaps most importantly, the authors fail to address the fact that passive investing appears to beat active investing not because of interventions of the type they study, but because passive investment in broad-based indices dramatically increases the probability of capturing the gains of the handful of stocks responsible for most equity returns.

Passive Investors

Passive investors — ETFs and index funds — are the most important development in modern day capital markets, dictating trillions of dollars in capital flows and increasingly owning much of corporate America. Neither the business model of passive funds, nor the way that they engage with their portfolio companies, however, is well understood, and misperceptions of both have led some commentators to call for passive investors to be subject to increased regulation and even disenfranchisement. Specifically, this literature takes a narrow view both of the market in which passive investors compete to manage customer funds and of passive investors’ participation in the capital markets. We respond to this failure by providing the first comprehensive theoretical framework for passive investment and its implications for corporate governance. To start, we explain that, to understand passive funds, it is necessary to understand the institutional context in which they operate. Two key insights follow. First, because passive funds are simply a pool of assets – their incentives are a product of the overall business operations of fund sponsors. Second, although passive funds are locked into their investments, their shareholders are not. Like all mutual fund investors, shareholders in index funds can exit at any time by selling their shares and receiving the net asset value of their ownership interest. Consequently, the sponsors of passive funds must compete on both price and performance with other investment options – including both other passive funds and actively-managed funds -- for investor dollars. As we explain, this competition provides passive fund sponsors with a variety of incentives to engage. Furthermore, the size of the major fund sponsors and the breadth of their holdings affords them economies of scale enabling them to engage effectively. An examination of passive investor engagement in corporate governance demonstrates that passive investors behave in accordance with this theory. Passive investors are devoting greater sophistication and resources to engagement with their portfolio companies and are exploiting their comparative advantages – their size, breadth of portfolio and resulting economies of scale -- to focus on issues with a broad market impact, such as potential corporate governance reforms, that have the potential to reduce the underperformance and mispricing of portfolio companies. Passive investors use these tools, as opposed to analyzing firm-specific operational issues, to reduce the relative advantage that active funds gain through their ability to trade. We conclude by exploring the overall implications of the rise of passive investment for corporate law and financial regulation. We argue that, although existing critiques of passive investors are unfounded, the rise of passive investing raises new concerns about ownership concentration, conflicts of interest and common ownership. We evaluate these concerns and the extent to which they warrant changes to existing regulation and practice.

Joint Distribution of Forecasts and Outcomes: Impact of Non-Normality on the Measurement of Forecasting Skill, with Applications to Analysts’ Target Prices

The purpose of this paper is to provide a detailed analysis of the joint distribution of forecasts and outcomes in the context of financial forecasting. We use Edgeworth expansions to model this joint distribution. In turn this allows us to assess the impact of non-normality, either in forecasts, or outcomes or both. This leads to multiple results; we can deduce the distribution of the forecast error; we can analyse the properties of the hit rate (H), as a statistical concept in its own right, and also in its relation to the information coefficient (IC); two tools that are used in the assessment of forecasting ability by active fund managers and financial analysts. Our paper contributes to the recent econometric literature on directional forecasting as well as the empirical literature that examines analyst performance. We find that the close link between H and IC under normality breaks down in the more general case. We provide further evidence on the richness of this approach by looking at simulation and empirical evidence.

“Active fund managers will always underperform in behavioural market?”

This paper mainly digs out reasons behind a common view that active fund managers perform poorly in behavioural market at most instances. Based on some economics theories and behaviour finance theories, the paper discusses five reasons arouse underperformance by active managers. Accordingly, these causes are divided into internal and external perspectives as well.

A sparse enhanced indexation model with chance and cardinality constraints

Enhanced indexation aims to construct a portfolio to track and outperform the performance of a stock market index by employing both passive and active fund management strategies. This paper presents a novel sparse enhanced indexation model with chance and cardinality constraints. Its goal is to maximize the excess return that can be attained with a high probability, while the model allows a fund manger to limit the number of stocks in the portfolio and specify the maximum tolerable relative market risk. In particular, we model the asset returns as random variables and estimate their probability distributions by the Capital Asset Pricing Model or Fama-French 3-factor model, and measure the relative market risk with the coherent semideviation risk function. We deal with the chance constraint via distributionally robust approach and present a second-order cone programming and a semidefinite programming safe approximation for the model under different sets of potential distribution functions. A hybrid genetic algorithm is applied to solve the NP-hard problem. Numerical tests are conducted on the real data sets from major international stock markets, including USA, UK, Germany and China. The results demonstrate that the proposed model and the method can efficiently solve the enhanced indexation problem and our approach can generally achieve sparse tracking portfolios with good out-of-sample excess returns and high robustness.

Indexing and Active Fund Management: International Evidence

Indexing and Active Fund Management: International Evidence

How disruptive can Smart Beta be to the South African Active Fund Management Fraternity?

ABSTRACTThis research paper explores the theme of Smart Beta and the current state of inefficiency of active fund fee structures in South African domestic equity unit trusts. The emerging understanding is that many of the latent sources of value-add (or alpha) of active fund managers are currently accessible in cheaper form via Smart Beta products. Smart Beta products use mechanical and automated rules to establish exposures to tradeable instruments that emulate many of the understood and replicable themes in current active asset management. We sample 91 well-known general equity funds along with nine local Smart Beta funds and demonstrate how disruptive Smart Beta products could be to the fee structures of many of these active funds. We do this by mapping the reproducible elements of the active return of these funds to fungible Smart Beta factors. We conclude with five broad predictions around the active fund management industry in South Africa. Additionally, we focus on how active managers might prudently align themselves with an understanding of what aspects of their value-add are not replicable in order to persist and thrive.

The Mutual Fund Investor

This chapter for an upcoming handbook on mutual funds (by Edward Elgar Publishing) offers an overview of the mutual fund market and the investors who inhabit it. On the supply side, mutual funds hold $16 trillion in financial assets and have become the largest component of our private retirement system. On the demand side, mutual fund ownership has become widespread, with 90 million fund-owning households composed mostly of middle-class, educated, and older investors.The portrait of mutual fund investors, painted by a large and consistent body of academic and government studies over the past few decades, is disturbing. Fund investors are mostly ignorant of fund characteristics, inattentive to risks (and opportunities) of different asset classes, and often insensitive to fund fees. Instead, fund investors tend to chase past returns and attempt to time the market. As a result, the average returns for fund investors (both in stock and bond funds) have significantly trailed benchmark market returns – according to some studies, by several percentage points.The role of financial intermediaries in the mutual fund market is also disconcerting. Often, financial advisers give fund investors conflicted advice, leading them to choose high-cost, under-performing funds on which the advisers garner commissions. Although some employers are shifting employees to low-cost, risk-appropriate balanced funds, many 401(k) plans remain less than optimal. Moreover, fund companies tout higher-cost actively managed funds, despite growing evidence that most, if not all, fund managers are unable to beat the market – particularly after fees.There are, however, glimmers of hope. Recently, many fund investors have moved to lower-cost index funds – reflecting a new sensitivity both to the importance of low costs and to the empty promise of active fund management. Target date funds have also established a beachhead in the 401(k) market. The recent clarion calls of the financial press reinforces these trends, as a growing drumbeat of stories emphasizes the importance of fund fees, the counter-productivity of trying to beat or time the market, and the emptiness of chasing past fund performance.

Sharpening the Arithmetic of Active Management

I challenge Sharpe’s (1991) famous equality that “the return on the average actively managed dollar will equal the return on the average passively managed dollar.” This equality does not hold in general. It is based on the implicit assumption that the market portfolio never changes, which does not hold in the real world because new shares are issued and others are repurchased. Hence, even “passive” investors must trade regularly in order to maintain their market-weighted portfolios. Since passive investors may trade at less favorable prices than active managers, Sharpe’s equality is broken. The changes of the market portfolio are large enough that active managers can add noticeable returns. Hence, active managers can be worth positive fees, which allow them to provide an important, beneficial, role in the economy — helping to allocate resources efficiently. Passive investing also plays a useful role, especially since the average active mutual fund manager has charged larger fees than their value added.

Practical Applications of Active Managers Are Skilled:On Average, They Add More Than $3 Million per Year

How can an investor tell whether a fund manager is any good? The most common measure of a manager’s skill has been gross alpha, but alphas decrease as assets under management rise. This article in <b><i>The Journal of Portfolio Management</i></b>, <b><i>Active Managers Are Skilled: On Average, They Add More Than $3 Million per Year</i></b>, maintains that active fund managers do add value. In an interview with <b>Institutional Investors Journals</b>, <b>Jonathan Berk</b> of <b>Stanford Graduate School of Business</b> and <b>Jules van Binsbergen</b> of <b>The Wharton School</b> urge investors to measure skill by the value added by the manager, factoring in both alpha and fund size. Using their measure, the evidence of skill can’t be attributed to luck. The evidence also shows investors seem to recognize and reward funds for this skill. <b>TOPICS:</b>Manager selection, portfolio construction

Is the Active Fund Management Industry Concentrated Enough?

We study the effects of market concentration levels on the active fund management industry (AFMI). We introduce a model of an AFMI equilibria in which size, performance, and effort are endogenously determined under a continuum of exogenous market concentration levels. Higher market concentration (for a given number of funds) leaves more unexplored investment opportunities and allows managers to more efficiently use industry resources, making marginal managerial effort more productive in creating alphas. However, with higher market concentration, managers can get higher compensation for their effort, causing a higher opportunity cost of effort. We find that in equilibrium, higher market concentration levels induce higher net alphas and AFMI size (the ratio of assets under active management to total wealth) if and only if gains from better investment opportunities exceed the consequences of higher managerial costs. We specialize the model to allow endogenous concentration levels and, using the Herfindahl-Hirschman and other indices, empirically study its key predictions in the United States equity AFMI in the last four decades. We find that, on average, AFMI net alphas and AFMI size increase with market concentration. Given the current low market concentration in the U.S. AFMI and with no change in managerial productivity/effort opportunity costs, an increasing market concentration is likely to increase both AFMI net alphas and size. We also look at equilibria with colluding fund managers and examine AFMI’s direct benefits.

Indexing and active fund management: International evidence

We examine the relation between indexing and active management in the mutual fund industry worldwide. Explicit indexing and closet indexing by active funds are associated with countries’ regulatory and financial market environments. We find that actively managed funds are more active and charge lower fees when they face more competitive pressure from low-cost explicitly indexed funds. A quasi-natural experiment using the exogenous variation in indexed funds generated by the passage of pension laws supports a causal interpretation of the results. Moreover, the average alpha generated by active management is higher in countries with more explicit indexing and lower in countries with more closet indexing. Overall, our evidence suggests that explicit indexing improves competition in the mutual fund industry.

Active Managers are Skilled: On Average, They Add More Than $3 Million Per Year

Active fund managers are skilled and, on average, have used their skill to generate about $3.2 million per year. Large cross-sectional differences in skill persist for as long as 10 years. Investors recognize this skill and reward it by investing more capital in funds managed by better managers. These funds earn higher aggregate fees, and a strong positive correlation exists between current compensation and future performance. <b>TOPICS:</b>Manager selection, portfolio construction

The Quality-Assuring Role of Mutual Fund Advisory Fees

Active fund managers implicitly promise to research profitable portfolio selection. But active management is an experience good subject to moral hazard. Investors cannot tell high from low quality up front and therefore fear manager shirking. We show how the parties mitigate the moral hazard by paying the manager a premium fee sufficiently high that the manager's one-time gain from shirking is less than the capitalized value of the premium stream he earns from maintaining his promise to provide high quality. Premium advisory fees act as a quality-assuring bond. Our model has a number of revealing extensions and comparative statics.

The quality-assuring role of mutual fund advisory fees

Active fund managers implicitly promise to research profitable portfolio selection. But active management is an experience good subject to moral hazard. Investors cannot tell high from low quality up front and therefore fear manager shirking. We show how the parties mitigate the moral hazard by paying the manager a premium fee sufficiently high that the manager's one-time gain from shirking is less than the capitalized value of the premium stream he earns from maintaining his promise to provide high quality. Premium advisory fees act as a quality-assuring bond. Our model has a number of revealing extensions and comparative statics.

Are Active Managers a Drag on Investor Wealth? Evidence from an Option-Based Estimation

We estimate an option-based value of a fund manager’s conditional market timing skill in bear market states. We combine this value with alpha based estimates of selection skill to give an overall valuation of active management. At the aggregate level, we estimate that the benefit arising from the option value of active fund management in bad times can be large enough to cover its unconditional overall cost. Our analysis suggests that by taking account of the option premium delivered by managers’ bear market timing skills, the longstanding mutual fund underperformance puzzle could be largely rationalized.

‘Benchmarking’ the benchmarks: How do risk-adjusted returns of Australian mutual funds and indexes measure up?

The primary aim of this study is to investigate whether equity fund managers are selecting appropriate self-nominated benchmark indexes for their funds. Specifically, we examine the performance of active Australian equity mutual funds and whether they demonstrate similar return performance and risk characteristics to their nominated benchmark indexes (for example, ASX 200 or ASX 300) from 2008 to 2012. Our findings suggest that active Australian equity fund managers do not outperform their self-specified capitalization indexes after risk and management fees and transaction costs. Further, managers appear to select stocks that are representative of investment characteristics associated with broad-based capitalization indexes. We also find that the ASX 200, ASX 300 and a range of alternative Australian capitalization indexes are highly positively correlated and demonstrate similar risk-return attributes. If fund managers cannot consistently match or better the performance of their nominated benchmark indexes after risk and transaction costs, then investors may be better off investing in low-cost index exchange-traded funds or equivalent investment vehicles.

Active Managers Are Skilled

Active fund managers are skilled and, on average, have used their skill to generate about $3.2 million per year. Large cross-sectional differences in skill persist for as long as ten years. Investors recognize this skill and reward it by investing more capital in funds managed by better managers. These funds earn higher aggregate fees, and a strong positive correlation exists between current compensation and future performance.