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Finance Series: investment-and-risk

Underperformance rife among active mutual fund managers

Almost all active fund managers fail to outperform the market once fees are extracted from returns, according to new research from Cass Business School.

Author(s): Professor David Blake - Cass Business School; Tristan Caulfield - University College London; Christos Ioannidis - University of Bath; Ian Tonks - University of Bath

UK investors would be 1.44% p.a. better off switching to a passive tracker fund, say researchers at Cass Business School. Their study claims that funds should split at critical size to protect investor returns. Almost all active fund managers fail to outperform the market once fees are extracted from returns, according to this research.

Ninety-nine per cent of all equity mutual fund managers are unable to deliver outperformance from stock selection or market timing, according to the 10-year study "New evidence on mutual fund performance: a comparison of alternative bootstrap methods" by the Pensions Institute at Cass Business School, part of City University London.

The study, which examined the monthly returns of 516 UK domestic equity (open-ended) mutual funds (unit trusts and OIECS) between 1998 and 2008, revealed an average annual post-fee alpha return of minus 1.44 per cent.

"This suggests that a typical investor would be almost 1.44 per cent a year better off by switching to a low-cost passive UK equity tracker," said Director of the Pensions Institute, Professor David Blake.

Yet active management remains the dominant investment strategy and there are recognised 'star' fund managers. Based on the findings just one per cent of fund managers actually prove to be 'stars', being able to generate superior performance in excess of operating and trading costs. However, they extract all of this for themselves via fees, leaving nothing for investors.

The Pensions Institute has also released a second paper "Improved Inference in the Evaluation of Mutual Fund Performance using Panel Bootstrap Methods" showing fund size has a strong negative effect on the average fund manager's benchmark-adjusted performance.

Using the same data set of UK mutual funds, academics found that a one per cent increase in funds under management led to a nine basis point drop in alpha per year.

Large funds tend to underperform small funds. This is because funds which attract inflows scale up their existing investment, driving up asset prices and pushing down yields.

Professor Blake said the findings suggested funds should consider splitting when they reach a critical size. "The most likely explanation for the negative relationship between fund size and performance is the negative market impact of large funds attempting to trade in size," he said. "This suggests that funds should split themselves up when they get to a certain size in order to improve returns for investors."

The studies were conducted using the statistical technique of bootstrapping, allowing the researchers to construct a distribution of returns which a fund manager could achieve by luck alone.

Working-paper versions of the research mentioned in this article are available for download below.

Attachment(s)
{New Evidence on Mutual Fund Performance: A Comparison of Alternative Bootstrap Methods}{https://www.cass.city.ac.uk/__data/assets/pdf_file/0003/355656/a-comparison-of-alternative-bootstrap-methods.pdf}; {Improved Inference in the Evaluation of Mutual Fund Performance using Panel Bootstrap Methods}{https://www.cass.city.ac.uk/__data/assets/pdf_file/0004/355657/improved-inference-evaluation-mutual-fund-panel-bootstraps.pdf}
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