Mutual funds feel the squeeze

Date: Thursday, November 9, 2006
Author: Jonathan Chevreau, Financial Post

Canada's high-priced mutual funds are being attacked from two directions -- by even higher-priced actively managed "hedge" funds and by low-priced exchange-traded funds, or ETFs.

At the World Hedge Fund Summit -- which concluded yesterday in Toronto -- a popular view was that ETFs and hedge funds nicely complement each other.

In effect, speakers argued, mutual funds are 90% closet index funds -- a fact Morningstar Canada confirmed last year when it scrutinized some of the most popular Canadian equity mutual funds.

What's wrong with that, you ask, given the growing popularity of passive indexing strategies? The problem is the 90% of the "beta" or market effect can be purchased more cheaply through real index funds or ETFs. Mutual funds may charge an annual fee of 2.5% that applies both on the "passive" part of the portfolio as well as the 10% where managers actually deliver "alpha" through their stock-picking "prowess."

Holt Capital Advisers' Christopher Holt argues such investors might be better served by separating the alpha and beta components of active management. Thus 90% of an investor's money could go in an ETF, with the rest going to a suitable hedge fund. Their "2 and 20" fee structure works out more cheaply since it applies only to 10% of the total portfolio. That's why hedgies think their high fees are relative bargains.

The best talk was by Dr. Randy Cohen of the Harvard Business School. That's the same place Peter Tufano toils. Tufano is one of three co-authors of the infamous global study showing how Canada's mutual fund MERs are higher than 18 other nations.

Asked about his colleague's study, Cohen said he finds Canadian MERs "amazingly high. In the U.S. I grew up with funds charging 100 basis points (1%). I found it amazing the rest of the world is much higher and that Canada's are even higher than western Europe's."

Nor have fees fallen with economies of scale, he said. He concludes high-priced funds appeal to "naive investors who are not fee sensitive and listen to their brokers ... It's an unfortunate situation, especially up here. People should look to alternatives where the fees will be lower."

Cohen reviewed the well-known literature familiar to most indexers; that in aggregate active management does not make back its own fees. However, Cohen says the highly intelligent, motivated and well-compensated managers of both mutual funds and hedge funds can beat the market and pick stocks. The problem is they may only have four or five "best ideas."

As their funds get large and popular they end rounding out their holdings with "filler," which amounts to closet indexing.

Cohen finds active managers do beat the market by 130 basis points but those gains are given back in trading fees, their own fees and from the drag of holding cash. Even average managers are good stock pickers but "Wall Street is sucking out all the money."

The solution is to eschew broad diversification and concentrate portfolios only in their best ideas.

If an investor owned 20 such funds each with just six good picks, they'd have a well diversified portfolio that might well beat the indexes.

So why don't they? Here, Cohen sounds like David Swensen in his book Unconventional Success.

"Mutual funds are asset gathering businesses." Success breeds mediocrity since no billion-dollar fund can hold just six names: any trading activity would move the market in those stocks.

Cohen's research shows smaller funds do better than larger funds and concentrated smaller funds do better still.

These smaller concentrated funds sound more like hedge funds, which have more flexibility to concentrate portfolios, use leverage or go short certain stocks or sectors.

But the most popular segment of the hedge fund industry are so-called "funds of funds" that are also in the asset gathering business.

These add extra layers of fees and end up being so diversified they look like just another broadly based mutual fund.

The results are typically little better than the yield of the average bond.

I was on a panel on the retailization of hedge funds, though as I noted in my blog, felt like the proverbial skunk at a picnic. My view is that with more than US$1.3-trillion invested in this asset class worldwide, a reversion to the mean is almost inevitable.

Mutual funds have largely failed to make the little guy rich and I fail to see why hedge funds will do any better as a mass retail product. That doesn't mean there may not be a place for them in pension funds or for single-manager funds for rich people who want to fill holes in their portfolios: perhaps long/short equity funds that do something neither ETFs nor mutual funds can give them.

Indeed, several American speakers confirmed the mass of money coming at them is making the game more difficult. There is a wider variance between the top managers and the bottom ones, said Maxam Capital's Sandra Manske.

Guess which will end up in Joe Average's high-priced fund of funds portfolio?

There was no shortage of charts showing allegedly superior returns for the hedgies but the survivorship bias that plagues mutual funds also affects hedge fund data.

See Swensen on this topic, where he reports that the collapse of Long Term Capital Management did not end up reported in hedge fund performance data bases.

We'll look further at this in Monday's Advisor Post.