A Thought or Two for Mutual Funds

Abstract

The mutual fund industry has not been able to add value to investors through performance. The objective of this article is to direct the attention of the mutual fund industry, its regulators, and clients to lessons that can be learned from the hedge fund industry. The lessons are synthesized from the findings of a number of published empirical research articles coupled with significant developments in the fund management industry. In an op-ed letter to the WSJ Mr. John Bogle eloquently describes the state of affairs in the mutual fund industry by associating it with the Emperor's New Clothes syndrome. He reports that the costs of running an equity mutual fund is about 3%. These costs are at all-time highs. In addition, published research shows that the key factor that determines whether or not a mutual fund makes use of derivatives is membership in a given family of mutual funds. Mutual funds tend to also adopt a herd behavior in security research and selection and performance management. The compensation of the mutual fund manager is based on assets under management with no link to fund performance. Mutual fund investment strategies, unlike hedge fund strategies, are far less flexible. Hedge funds tend to generally perform well in up as well as down markets. Hedge funds sell short, leverage, use derivatives, control redemptions, and tie compensation to performance. Hedge funds use these tools for exploiting arbitrage opportunities created by indexing, herding of performance, herding of security selection, and rigid legal and institutional structures. Hedge fund managers are exposed to idiosyncratic risk. The mutual fund industry along with its key constituents, need to explore new avenues for adding value.