Is It the Fund or the Fund Manager that Fuels Performance?Published: May 10, 2006 in Knowledge@Emory
When it comes to the world of work, mutual fund managers are a respected breed. But are they a dying breed? Klaas P. Baks, assistant professor of finance at Emory University’s Goizueta Business School, has conducted research that may shed some light on the future of the mutual fund manager in the world of finance.
Mutual funds are closely watched, particularly by individual investors. Take, for instance, one of the most famous mutual fund managers in recent history, Peter Lynch. When Lynch started managing the Fidelity Magellan Fund in 1978, it had assets of more than $20 million. When he retired from that position in 1990, the fund had assets of $14 billion. Lynch’s standing as a stock-picking superstar is difficult to dispute, but is that so for all mutual fund managers? To what extent do managers determine the performance of a mutual fund?
Two entities have direct influence over a mutual fund’s performance. Part of the performance of a mutual fund rests with the manager, because he or she is in charge of the investment decisions, while part rests with the fund organization, which can influence performance through administrative procedures, execution efficiency, corporate governance, quality of the analysts, relationships with companies, and the like.
Baks set out to do what has not been done before in academic research: separate the fund manager from the fund organization as a means of analyzing performance to determine just how important the manager truly is. “There are reasons to believe that both are important to the performance of the fund,” explains Baks, whose paper “On the Performance of Mutual Fund Managers” is currently under review at the Journal of Finance. “The difficulty is that typically, performance is seen as a joint output of both managers and funds. Think about a tennis game in which you would only observe doubles play. If one only sees doubles play, then it’s hard to assign which player is good and which is not because one only observes the team. It may be one or the other. Most of the studies have used mutual funds and mutual fund managers equivalently even though they are not the same entity. Both have a role in performance. This is the first paper that disentangles that.”
Baks sets out to isolate performance by tracking mutual fund managers as they move from firm to firm. The study examines the performance of mutual fund managers using a newly constructed database that tracks 2,086 managers of domestic diversified equity mutual funds during their careers. The 2,086 managers in the sample manage 1,602 funds with a total of 6,287 fund years during the period from January 1992 to December 1999. Important for Baks’ purposes is that mutual fund managers do indeed change jobs frequently. In the eight years from 1992 to 1999, a manager of a domestic diversified equity fund works on average for 3.6 years, manages on average 1.7 funds, stays at one fund on average 3.1 years, and works on average for 1.2 management companies. In the end, few managers beat their benchmarks at all the fund companies where they worked. Abnormal performance of a manager typically varied from fund to fund suggesting that manager changes, on average, had little impact on abnormal performance.
While the first part of Baks’ paper examines manager performance, the second part investigates the relative importance of funds and managers for a manager-fund combination’s performance. Baks constructs a model that separates manager and fund inputs and measures their effect on ultimate fund performance. In this framework, he finds that the fraction of abnormal returns contributed by the fund ranges from approximately 90% to 50%, depending on one’s prior beliefs about the existence of skill among mutual funds. The remaining 10% to 50% is contributed by the manager. That is, if a new manager who is half as productive as the previous manager commences at a fund, then that fund only has to be 5% to 50% more productive in order to maintain the same abnormal performance. “The layman conclusion here is that the fund is more important than the manager for performance,” explains Baks. “For some people that is fairly surprising because we tend to think that the guy who makes the investment decisions must be the most important determinant of fund performance. That happens not to be the case.”
Baks is not arguing that exceptional managers are non-existent, but on average, he concludes, manager status is more about marketing than true stock-picking prowess. On average, investors should not be solely basing their investment decisions on the abilities of the mutual fund manager. “This issue is a little less relevant these days because funds have discovered the drawback of hyping your own manager too much,” says Baks, who is already applying the same model he developed in this paper to examine if analysts or brokerage firms drive the performance of stock recommendations. “These mutual fund managers realize they are worth money and when they move, everybody follows that move. Mutual funds companies don’t like that power to be in the hands of the manager. Today they mention whole management teams, which ensures that the fund’s investment strategy continues and existing investors do not defect to a different fund even if a manager leaves for another fund.”
In our discussion on the future of work, does Baks’ conclusion about mutual fund managers’ questionable influence on performance signal the end of their elevated positions in the high-powered world of finance? Not likely, says Baks. “In active fund management, there will always be a role for a manager to interpret firm data such as earnings and projects they undertake. There is value to that. The prevailing theory among academics states that active management can’t add value because markets are efficient and it is impossible for anybody, including fund managers, to figure out which securities are undervalued or overvalued. Reality has shown, though, that over- or undervaluation can occur in the short term. People believe that, and they believe that there are certain people who can figure that out.”