Mutual Fund Managers Skill, Luck, And Fees

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Jonathan Berk and Jules van Binsbergen from Stanford University conducted a study in 2013 that uses dollar value a manager adds each year as a measure of mutual fund management skill. They found that the average mutual fund increases value by about $2 million per year and that such mutual fund management skill continues for at least 10 years. Investors recognize mutual fund managers skill and reward it by investing more assets and paying higher fees. Berk and Binsbergen found that the top performing funds earn higher fees relative to their competition. Compensation and fees are positively correlated, funds charging higher fees performed better in future periods.

Management firms and investors share mutual fund managers skill gains

Other studies show that passive mutual funds outperform active peers implying that mutual fund managers skill is non-existent. In 1973, Princeton economist Burton Gordon Malkiel noted that a blindfolded investor could select stocks by throwing darts at financial pages that will perform just as well as the ones selected professionally. William D. Norhaus, a Yale economics professor, concurred with Malkiel in 2014 noting that active funds performance resembled flipping a coin, meaning it did not persist and that selecting stocks at random will do slightly better than a money manager.

Over time, studies’ conclusion that index funds may present better value for most investors relative to active management has been distorted to mean that mutual fund managers skill required to beat the market is non existent. Berk and Binsbergen discovered that management firms and managers shared benefits from mutual fund management skill with investors. Berk and Binsbergen’s study showed that measuring mutual fund managers skill by using gross alpha – excess returns over a defined benchmark such as the S&P 500 before fees – provides an incomplete picture. Berk and Binsbergen also use Vanguard index funds as benchmarks to measure alpha given that investors can actually use such funds as alternatives. Such method provides a more realistic alpha measure.

Peter Lynch’s monthly alpha for managing Fidelity Magellan fluctuated between 20-200 basis points. He obtained 200 basis points of alpha in his first five years of managing the fund. It seems that Lynch does not have mutual fund managers skill as alpha did not persist over time. However, what alpha leaves out is growth in assets under management driven by asset price gains and fees charged. Fidelity Magellan‘s gains went from less than $1 million per month in the first five years to over $20 million per month in the last year. Assets under management grew from $40 million to more than $10 billion today. Berk and Binsbergen concluded that mutual fund management skill measures need to include return, growth in assets under management and management fees. Investors share benefits of mutual fund management skill with asset managers as they pay a premium for superior results.

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