Last week there was a flurry of posts in the blogosphere about how dumb mutual fund managers are. Michael Stokes of MarketSci kicked off the discussion with I Just Don’t Get It (the Failure of Mutual Funds to Think Outside the Box). It was followed by other supportive posts such as the one by Damian at Skill Analytics.
I would like to address the very real points raised by these bloggers. Most of the complaints fall into two categories. The main one goes something like this: “I’ve got a great system, why can’t Wall Street recognize me?” In both these cases, the writers identify themselves as “quants” and blame the bottom-up fundamental stock picking mindset as mental barriers to superior mutual fund performance.
The second complaint is voiced more indirectly. If there are great quantitative systems or thinkers around, why can’t the average mutual fund outperform?
Would you go to a pizza joint for sushi?
There are a number of misconceptions at work here. These writers fail to understand that asset management is a business. More importantly, they fail to understand what mutual fund managers are selling.
Investors use mutual funds as building blocks in their portfolios. Allocate 60% to stocks, 40% to bonds. Within the stock portfolio, allocate this much to large caps, that much to small caps. Maybe if you have a great growth manager, then offset it with a value manager, etc.
Style drift is death to mutual fund marketing. Investors don’t like surprises. If you bought a fund that was labeled as a mid-term government bond fund, what would your reaction be if you found it stuffed full of emerging market bonds? What is the mutual fund manager’s business risk if the emerging markets blew up?
Do you go to a pizza restaurant and order sushi? Mutual fund managers are acting rationally. They are delivering what their customer wants. Straying from their mandate is the equivalent of offering sushi at a pizza joint. While bloggers such as Stokes, who work mainly on market timing models, have some very interesting ideas. Unfortunately for him, many of their ideas don’t fit in the mutual fund “boxes”.
He’s just not that into you
There is admittedly a cultural divide between fundamental stock pickers and quants. I have experienced that all my professional life. The job interview described by Damian, a quant, by a fundamental stock picker was an example of that divide.
Accept it. He’s just that into you.
I would take exception, however, to some of the points raised in his post.
Reliance on a single approach: Not all fund managers are fundamental stock pickers. There are many quant firms out there. One example of prominent name who has been in the news a lot recently is Jeremy Grantham of GMO.
Strategy Scaling Requirement: Damian admits that “many of the quantitative strategies that people put forward on the net (including my own) simply won’t scale to the size of a $1b fund.” If a strategy isn’t very scalable, isn’t its commercial value limited?
Fully invested: See my previous comment about ordering sushi at pizza joints. Mutual funds are there to provide an investor exposure to an asset class. Unless you style yourself as a market timing fund or an absolute value fund, then not being fully invested all the time is style drift.
100 stocks or more = Indexing: As a quant, he should know better than that. If I were to hold an equal weighted portfolio of the top 100 stocks in the S&P 500, the forecast tracking error, according to most risk models, would easily be in the 3-5% range. (Note that tracking error is defined as the forecast one-standard deviation return difference between a portfolio and its benchmark).
If you're so smart, start a hedge fund
I have also done a lot of interesting work as a quant during my life. You can find some examples here and here – and they only scratch the surface of my thinking. Most notably, some of my models didn’t blow up in August 2007 when many equity quant funds melted down, indicating a crowded trade. I recognize that in many cases, the chemistry just isn’t right.
If people who complain about mutual funds believe that they have a real alpha, then the answer is simple: go start a hedge fund! Hedge funds are supposed to be the embodiment of pure alpha.
Oops! We know how that turned out for a lot of people.
In reality, there is a lot more to portfolio management that knowing what to buy and sell. The case of Peter Schiff is a recent example but he is not alone. That’s why I am working on my book project.
Amateurs pick stocks, sectors, markets, time markets, etc. Professionals manage portfolios.