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Measuring Skill In The Mutual Fund Industry

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A study on the top performing mutual funds indicates that future performance of a mutual fund can be determined by the past fee aggregation of mutual fund managers.

The study contradicts other academic reports, asserting that traditional measures such as the gross and net alpha, used in most studies of mutual fund manager skill, fail to properly measure a mutual fund manager’s contribution. Such studies utilize volatility as a method to evaluate manager performance. The use of the average abnormal return net of fees and expenses explain why previous studies have failed to find evidence of mutual fund manager skill. Instead, the study used a value added calculation that determined the gross extraction of money from the market.

A key study formula was that “the total value the manager extracts from markets is equal to the amount of money the fund charges in fees, minus any money it takes from investors: the percentage fee multiplied by AUM plus the product of the return to investors in excess of the benchmark and AUM. This quantity is the fund’s gross excess return over its benchmark multiplied by assets under management, what we term the value added of the fund.”

mutual fund

The study found that higher skilled mutual fund managers control larger assets and also deliver better performance, on average. The most surprising result was that researchers discovered “investors appear to be able to identify talent and compensate it: current compensation predicts future performance.”

Stanford study on mutual funds

The paper, authored by Jonathan Berk and Jules van Binsbergen of Stanford University, rejects the “Null Hypothesis” that mutual fund managers have no skill.  “Not only do better funds collect higher aggregate fees, but current aggregate fees are a better predictor of future value added than past value added,” the report said.

The study contrasts existing academic work and relies on three key assertions. First, the study says they identify managerial skill correctly through their value added analysis. This is the most important study component, the authors assert, because it rejects academic work that claims mutual fund managers have no skill. Second, the study used a Vanguard benchmark to calculate fund alphas rather than relying on a risk model. Risk models often measure volatility as a degree of risk. Third, the study utilized a full cross-section of mutual funds, including funds that invest in international stocks.  Previous studies that supported claims that mutual fund managers did not provide value utilized only mutual funds that trade US stocks.

The authors use the career of famous mutual fund manager Peter Lynch’s to illustrate the case that using alpha measures rather than value added to measure skill misrepresents manager value. In his first 5 years managing Fidelity’s Magellan fund, Peter Lynch had a 2% monthly gross alpha while managing average assets of about $40 million. Fast forward to his last 5 years, when Lynch had a gross alpha was 20 basis points per month on assets that ultimately grew to over $10 billion. Based on the lack of consistency in his gross alpha numbers, the report says it would be easy to mistakenly conclude that most of Peter Lynch’s early performance was due to luck rather than skill. “In fact, the value he extracted from financial markets went from less than $1 million/month to over $20 million/month, justifying his wide spread reputation as the most skilled mutual fund manager of all time.”

To read the full study click here.

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