Mutual funds that invest in corporate stocks can be broadly divided into two categories: index funds and actively managed funds. An index fund attempts to mirror the return of a stock market index like the Standard and Poor 500 (S&P 500). These funds usually charge low fees and will rise and fall with the market index. An actively managed fund relies on the investment skills of the fund managers to beat the performance of a market index like the S&P 500. Actively managed funds charge fees that are usually at least double those charged by an index fund. The amount that an actively managed mutual fund rises above a market benchmark like the S&P 500 is referred to as alpha (the influence of academic economics in finance seems to have resulted in an attraction to Greek letters).

According to Ben Warwick's book Searching for Alpha: the quest for exceptional investment performance, in twenty of the last thirty years more than half of the actively managed mutual funds have failed to beat the S&P 500. In 1998 only 18% of the actively managed funds beat the index. Investors in actively managed mutual funds should take the fund prospectus warning "past performance is not necessarily an indicator of future performance" seriously. Many of the funds that beat the index one year did not do so the next.

The fact that most funds do not beat the overall stock market should not be surprising. The majority of money invested in the stock market comes from mutual funds and institutional funds (pension funds, college endowments and insurance companies). Since these funds make up most of the market, they can't all out perform the market. However, there will always be funds that yield exceptional performance. Searching for Alpha discusses the techniques that successful funds use to produce this performance. It also discusses some of the pitfalls (risk) and conflicts between the interests of the fund managers and their customers.

The implied promise held out to investors in actively managed mutual funds is that in exchange for higher fees (relative to index funds), the actively managed fund will deliver superior market performance. Warwick points out that there are a host of barriers to fulfilling this implied promise. One of these is fund size.

The larger a mutual fund gets, the more difficult it becomes to deliver exceptional performance. A large fund must invest more broadly and must invest in companies with a larger capitalization. Large companies are more closely followed and their stock prices will tend to accurately reflect their value (e.g., there will be fewer bargains). The fund managers must also work harder to avoid having their trading impact the market. For example, by buying a large block of stock that the fund managers believe is under-priced there may be a market impact that drives the stocks price up, reducing profit.

Although fund size runs counter to "alpha generation", fund managers have a strong motivation to let the fund grow as big as possible. Most actively managed mutual funds charge a fee based on fund assets (e.g., 1.0 to 1.5 percent of assets). The bigger the fund gets, the more money the fund managers make. This accounts for the common behavior seen with mutual funds, where a little known fund with a capital base that is small enough to invest efficiently will have exceptional performance for the first year or two. The mutual fund company will then use the funds history of exceptional performance to market the fund and grow its capital base.

When investment managers are paid a percentage of the fund profits above the market benchmark (e.g., they are rewarded for alpha generation), their interests are more closely aligned with those of the fund investors. Many hedge funds reward their managers in this way. Unfortunately for the average investor, hedge funds are only open to "high net worth individuals" (e.g., the rich). I am not aware of any mutual funds with low investment minimums (e.g., $5,000) that is structured this way.

The growth in the number of hedge funds is another hazard to exceptional mutual fund performance. Warwick points out that many of the most skillful mutual fund managers are hired away by hedge funds, where their financial rewards are greater and there are few restrictions on investment techniques.

Another barrier to mutual fund investment return is taxation. Warwick includes an excellent chapter on the tax issues that effect mutual funds. In an attempt to encourage long term investing (which has allegedly served countries like Japan well), Congress has tied tax rates to the length of time that an asset is held. This is summarized in the table below (slightly modified from Searching for Alpha, table 9.1):

One way that actively managed funds "generate alpha" is by frequent trading. Many funds will have yearly asset turnovers of 100% or more. If the money invested in the fund is taxable, it will be taxed at a rate of almost 40%. When the net yield after taxes of an actively managed fund with this kind of high turnover is compared to an index fund, which has low turnover, the index fund will be a better investment in many cases. Warwick points out that stock options can be used to lock in profits and avoid losses, but many funds do not use options.

By law mutual funds are supposed to be conservative, which in theory limits their potential losses and makes them more suitable for the average investor. This limits the ability of mutual funds to "generate alpha". One of the techniques for "alpha generation" discussed in Searching for Alpha is arbitrage. Arbitrage involves buying an asset in one market and selling the asset or a related asset in another market. For example, British Telecom is sold on both the London Stock Exchange and on the New York Stock Exchange (NYSE). If British Telecom stock is priced lower on the NYSE than the London Exchange, the stock can be bought on the NYSE and sold in London. Since exchanges are electronic, the transaction can be completed instantly, yielding a risk free profit. The spread between the two exchanges is usually small, when it exists at all. So leverage (borrowed money) is used to generate a profit from the small mispricing between markets. Mutual funds are not allowed to use significant amounts of leverage.

There are a number of sophisticated typesof arbitrage. These include various kinds of stock and bond arbitrage and interest rates swaps. In contrast to arbitrage of the same security in different markets, many of these sophisticated forms of arbitrage can be risky. The Long-Term Capital Management hedge fund lost billions of dollars when the market turned against their arbitrage bets.

One of the few areas where the mutual fund investor may be able to gain "alpha" is in funds that invest in companies with small market capitalizations (so called "small cap" funds). Small companies are not followed by many market analysts. This means that there may be unrecognized bargains. An actively managed fund with a good research staff and a talented fund manager may be able to build a portfolio of small cap stocks that beat the market. However, small companies are more sensitive to economic downturns and small cap stocks may fall faster than the stocks of large companies in a recession.

Searching for Alpha can give a bleak impression for the prospects of "alpha" for actively managed mutual funds. There are a number of significant barriers to exceptional mutual fund investment performance. Mutual funds are not allowed to use many of the techniques, like leverage, that can "generate alpha". Perhaps we should simply build our own portfolio of stocks.

There are a number of problems with this. Investment is very time consuming and most of us have jobs, families and other interests. Nor do most of us have the knowledge and discipline to be successful investors. Warwick includes a fascinating chapter on "Behavioral Finance", which discusses many of the mistakes that both amateur and professional investors make.

One of the virtues of Searching for Alpha is that it is a quick read compared to finance books like Black-Scholes and Beyond. But the book is flawed in several areas. The books is not detailed enough for market professionals and MBA students. On the other hand, it assumes more knowledge than many general readers possess. Also, as I've noted, many of the techniques that "generate alpha" are not available in funds that most of us can invest in. This leaves the impression that the book started out being a more detailed work for market professionals but was simplified at the urging of the publisher.

Searching for Alpha provides an overview of many of the theories in modern finance. There are few equations and the concepts are explained broadly. This is not necessarily a fault, but when Warwick attempts to describe some ideas via stories the narrative gets away from him. The stories serve only to confuse his explanation. The book contains a number of tables and graphs. Some of these have keys that are mislabeled (for example, figure 4.3). Others seem to argue against the idea being discussed. In Chapter 2, for example, which discusses the difficulty of beating the S&P 500, figure 2.1 shows that in ten out of thirty years, between 1970 and 1999, over half the mutual fund beat the index, in some cases by substantial margins. Warwick never comments on the success of actively managed mutual funds during some time periods. He concentrates on the last ten years, where many actively managed mutual funds have done poorly in comparison to the overall market. This is too bad, since we may be entering a regime shift where the investment climate will be more like the 1970s then the roaring 1990s.

Disclaimer

Nothing that is written here should be interpreted as reflecting the views of my employer. The bearcave.com domain is mine and these opinions not necessarily shared by anyone else. In writing this review, I am not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional person should be sought. Damn it Jim, I'm a software engineer, not a licensed investment advisor.

Ian Kaplan - October, 2000
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