I Just Don’t Get It (the Failure of Mutual Funds to Think Outside the Box)
I’ve been thinking a lot lately about what I see as the utter failure of the actively managed mutual fund industry to provide any real value to investors.
As a developer whose programs have consistently outperformed the market by a healthy margin (real-time and independently-audited), it’s difficult for me to comprehend the current state of traditional investing where beating the market by an extra 1-2% per year constitutes outperformance.
But it really doesn’t matter because at this moment, that is the way it is. So what really pains and befuddles me is why the mutual fund industry, with such a low hurdle to clear, doesn’t reach out to folks like me to apply some of our concepts to their more fundamental approach to investing; in other words, why they don’t think outside their little box.
Now the way I trade could never be applied as-is to a mutual fund (hedge fund yes, mutual fund no), but that’s not what I’m proposing.
I’m proposing that those concepts only be applied to transactions that would already be taking place with or without a quantitative component: managing fund inflows (new money), expected outflows (redemptions), and position changes within the portfolio. Delay a purchase/sale here by a day or so, scale into a position there, etc.
Can anyone honestly tell me that a developer who has produced as much positive consistent alpha as we have couldn’t apply those concepts to a mutual fund and produce that magical and much sought after 1-2% annual outperformance? I think not.
What would it take to pull it off?
Simple. Lock me (and/or a handful of other quantitative minds who have proven their ability to outperform) in a room for a month, with food and water slipped under the door thrice a day. I used to think I didn’t come cheap, but compared to some of the Wall Street bonuses splashed across the financial press, I work for third world wages. Hello Morningstar 5-star rating.
I just don’t get it.
Happy Trading,
ms
P.S. I’ll respond in advance to what would have probably been the first comment to this post, “but Michael, Wall Street already uses these quant-gurus, and yet they still underperform”. To that good sir I call bullshit. Yes, Wall Street employs quants. No, they haven’t done a good job as it relates to mutual funds (as evidenced by their subpar performance). Why? I haven’t the foggiest clue. Perhaps it has to do with dropping their creativity off at the door when they entered the halls of Academia.
To stay up to date with what’s happening at the MarketSci Blog, we recommend subscribing to our RSS Feed or Email Feed.
Filed under: Random Stuff | 23 Comments
2 main concepts you have to bear in mind:
1. large political organisations do not permit alternative thinking…if so there would be less of a mess in the world right now…the bankers had to keep rolling the dice for fear of their jobs or shareholder ire (“You lost market share????”) ..similarly most portfolio managers cannot step out of their boxes for fear of their jobs, they are obliged to follow the herd since any aberration that is not immediately successful will incur the wrath of a superior will punish any “mistakes”. Finance is one big marketing con, in general.
2. the more people there are that exploit an edge, the more the edge reduces.. you should really be glad the mutual fund industry is behind you.
Just my two penneth.
There are things that you can do, but the mutual funds can’t.
You can go short, mutual funds can’t. You can buy shares in any quantities you want, mutual funds must buy in a sizable quantity of shares because they have so much money to manage and investing peanuts in funds isn’t feasible at all. You can buy shares that mutual funds can’t due to their strategy restrictions or their policies ( some mutual funds can’t buy small cap funds because of their positioning). And so on.
RE to Ngu Soon Hui: Yes, I know the limitations that mutual funds have…you’re missing the point of my post. I’ll use your “you can go short” example. Fund ABC has X number of dollars in cash that they want to deploy in some group of stocks beginning tomorrow (either money that was on the sidelines or investor inflows). The quant side of the model shows a high probability that tomorrow will be a down day. So Fund ABC holds off on deploying that capital until the market environment is more favorable. michael
MS,
Even though I am in what I would call “the brunch” phase of my career (early in the morning, but well awake long enough to clear the sleep from my eye), I have worked in just about every facet of asset management, and I am consistently befuddled by the poor performance of professional money managers. That said, I posit a few ponderables about WHY they are so bad:
1) Incentives/Risk Aversion: as you know, most money managers are really asset gatherers, skimming their fees off the top of AUM, not performance. Unfortunately this leads to an asymmetric risk aversion model of money management. Rightly or wrongly people benchmark their manager’s performance against a well known benchmark (simple framing heuristic). Since I am sure you are familiar with the risk-aversion “S” curve I won’t get into the details, but suffice it to say the visceral reaction an investor (client) has to underperformance is far more pointed than their reaction to outperforming the benchmark. Money flows more swiftly out of funds that underperform by, say, 200bps, than it flows in for 200bps of outperformance. Gathering assets takes time; losing them doesn’t. Since there is little payoff for marginal outperformance (zero profit participation), and a heavy penalty for marginal underperformance, PMs manage towards an alpha of zero (after fees): hug the benchmark and your career is safe. Furthermore, a single drawdown of any magnitude is likely to stain ones reputation for years, whereas (again) a single positive year is likely seen as “lucky” or flash in the pan. (This is nothing new, but it’s still true).
2) Regulations: while there are some (albeit a miniscule number) of actively managed funds that actually manage concentrated or unique strategies, the majority of funds are boxed in by diversification rules, bans against shorting, etc. As you know, the greater diversity assets you hold the closer you are going to perform “as the market” (for the few novices in the crowd just look at the Dow and SPX correlations…they are incredibly high even though the two indices have different methodologies, weightings, sector exposures, etc) in fact, if i recall correctly, after about thirty stocks you are at a .8-.9 correlation and beta to the market. Today it is (near) impossible to run a portfolio that DOESNT act like the funds respective “market”, simply because of the forced diversification.
It is also incredibly dificult to change ones investment/trading strategy in a fund that requires are the requisit fillings, risk analysis, and BoD approval. Therefore it’s tough to be agile and “try new things”.
3) Assets kill performance: on top perverse misalignment of incentives “asset gathering” promotes, the game of “getting big and collecting fees” is antithetical to efficient investing. A) As you grow in size your trading agility decreases as your ideal position sizes are corrupted by a major exogenistic (non investment) factor: moving the market. The elasticity of prices with respect to liquidity severely hinders a funds actual investment universe and forces PMs down their “best ideas curve”. B) Since there are “upper bounds” in how much you can invest in any one stock (by virtue of point “A”) you are forced to go down your investment prospects list to simply have somewhere to park excess cash. PMs aren’t paid for holding cash (it’s seen as the client’s role to measure their risk tolerance and balance accordingly), and the presence of cash reserves may (rightly or wrongly) signal that the PM is out of ideas (a negative signal).
4) Client representatives/Buyside advisors: these geniuses love to take complex situations and boil them down to nothing more than a series of comps from traditional style-box analysis. If you can’t be bucketed into a well defined style pension/insurance/RIA advisors won’t even look at you. God forbid they have to take the time to understand products and explain a complex subject to their clients. Rather they prefer to simply have a matrix by which they can punch in return streams and holdings then say “XYZ is best, look at their Sharpe!” When I launched one of those fabled HF Replication products the toughest hurdle to clear was figuring out how to “box” the fund–not the mechanics, not the methodology, they only asked “what box would this go in?”
5)Finally, to sum everything up, MF companies are big, slow moving organizations. On top of the regulatory hurdles most funds are seen not as alpha generators, but as product shelf fillers. A “good” mutual fund shop has a product for every “box” and they need to keep their presence in each category regardless of performance or rationality. If a PM on, say, a large cap value fund underperforms heavily then the PM is simply replaced because every platform needs a LCV fund. To the contrary, should you outperform your market, but exhibit any kind of style drift, you can just as easily be canned because people will complain “they dont know what they’re buying”. And god help you if you come up with a new investing metric to base your analysis on—you’ll have to prove it works to your handy dandy risk department for well over 6 months, but which time it’s probably arbed out anyways.
At the end of the day it’s the structure of the system that has set portfolio managers up to fail–all in the name of “protecting” retail investors. The only places you see demonstrable alpha is in the HF community because they can trade nimbly, react quickly, generally aren’t big enough to move markets, and have an aligned incentive structure. Is it perfect? No! But you are never going to eliminate all principal-agent problems, which is what this REALLY comes down to. HFs are just better agents.
MS, as an infrequent reader, but big fan, I don’t know exactly how you constrain yourself or what limitation you have in your investing styles, so I can’t speak to specifics of You v. World. But even if your track record was scalable, adaptable, and manageable (not just profitable from a small AUM pov) I guarantee you would have trouble launching any sort of MF due to the advisory conflicts i listed above. And, unfortunately, I guarantee you would never be able to invest the way you do now if you had a BoD, risk team, and SEC watching for the slightest hint of departure from your stated investment method (even if it works). It’s a shame that the regulated investment world has raced to the bottom of a zero-sum game, but it’s a fact of life.
I hope this answers a few questions, or at least gets you thinking.
Feel free to hit me up to speak further.
1-2
RE to 1-2: well done sir. I especially liked your comments in part 1 RE: the difficulties of gaining assets, the ease of losing them, and the assymetrical reaction by investors for over/underperforming their benchmark. Again, very well done.
My Significant Other asked me once I work so hard to do what I do (as an “alternative” asset manager sliding along the underbelly of the “traditional” financial world) when I could just put on my three-piece suit, a happy grin on my face, and probably earn a lot more money playing the game.
I told her that the most important thing in the world for me, is to be able to look myself in the mirror and know, really know, that I did everything I could to be the very best at what I do (not to say I am, just that I tried). And that I’d rather die a poor man who met that standard, than a rich man who didn’t.
Your comments are a reminder that just because it’s big and profitable, doesn’t make it right, or smart, or good.
Good stuff.
michael
Mike – I’ve posted a response to your question on my blog….it covers a few of the items that other have in these comments as some other areas as well – mainly focused on the personalities that run these funds. Comments welcome.
http://skillanalytics.wordpress.com/2009/02/18/why-mutual-funds-dont-think-outside-the-box/
“quant managers” in the mutual fund world use almost exclusively fundamentals as their inputs (in contrast to their successful cousins in the hedge fund world- Jim Simons, David Shaw etc)—my testing shows that momentum, relative strength, seasonality, market direction, industry direction, and technical trading rules account for 95% of a stock’s performance. Only two fundamental variables are truly powerful and robust—estimate revisions and stock buybacks/repurchases. When i read fund manager’s model descriptions in publications like barrons etc, invariably the focus goes on to discussing “classic inputs” like P/E, dividend yield, ROE etc etc. Interestingly enough, these variables have degraded signficantly in their alpha over the last ten years (no focus on adaptation here). Buying and selling on price alone is intellectually undesirable for both the institutional clients, the fund company, and the Harvard educated manager (who believes through the course of their academic experience that their judgement is always right). As a consequence there is almost always a qualitative component where they have a research team to review a short list of stocks. Smart and successful people always think that doing intensive fundamental research must be superior than simply buying long term momentum or fading short term momentum. Sadly these people are idiots, but they control all of the money.
Ultimately most of the good stuff you put on your site is rooted in robust simplicity. While scientifically, this is considered desirable, simple means stupid in the businessworld. I have spoken to colleagues in the private investment counsel, and fund management realm that have never taken the time to backtest anything, and have absolutely no clue what an RSI is, or whether moving averages are useful or not. They operate on philosophy—they always tell me that they buy good companies that are undervalued. Yet none of them has ever had a year of even 5% outperformance. However most of them make a million or more a year and appear on business TV here in Canada from time to time.
1-2 identified most of the forces at work. Let me add one more: endogenous risk. That 1-2% alpha by backward-looking techniques work, until it doesn’t and the fund takes a bath (and lose the all-important AUM).
http://www.voxeu.org/index.php?q=node/1118
Underpinning this whole process is a view that sophistication implies quality: a really complicated statistical model must be right. That might be true if the laws of physics were akin to the statistical laws of finance. However finance is not physics, it is more complex, see e.g. Danielsson (2002).
In physics the phenomena being measured does not generally change with measurement. In the finance that is not true. Financial modelling changes the statistical laws governing the financial system in real-time. The reason is that market participants react to measurements and therefore change the underlying statistical processes. The modellers are always playing catch-up with each other. This becomes especially pronounced when the financial system gets into a crisis.
This is a phenomena we call endogenous risk, which emphasises the importance of interactions between institutions in determining market outcomes. Day-to-day, when everything is calm, we can ignore endogenous risk. In crisis, we cannot. And that is when the models fail.
@MS-
Thanks for the kinds words.
Just remember, whether it’s sports cars or mutual funds, size tends to be the major impediment to performance.
@david – your quant-fundamental (“quantamental”?) assesment is spot on. I had to deal with reframing “what a quant is”, and explain that MF quants are rarely stat-arb traders on a daily basis. In the mutual fund world the quant process is far more about creating an effective (i’ll leave realized efficacy for another day), complex ranking/filtering system to distill the massive amounts of data available. Now that im out of that world I must admit the ONLY major argument FOR quantenmental investing is that you are able to eliminate the behavioral biases that plague traditional stock pickers. However, at the end of the day, I have yet to find a quantendental fund that is able to perform over the long run. They are especially vulnerable to dramatic shifts in the investing environment, and are very inflexible about whether/when to break their trading rules to protect capital. After eeking out .5-1% alpha pa for ten years all the funds tend to give it all back and then some in year 11.
@peaty – great point…Heisenberg investing strategy, no?
Call me simplistic, but fund managers want to beat their peers.
They don’t want to make extra money for the clients.
Thinking outside the box risks underperformance. That could cost them their jobs.
Michael,
Great post, as usual. This is why this is one of my favorite blogs — you post some thought-provoking ideas and the resultant responses are of equally high caliber.
A lot of the points above address a question that I’ve always had, but never really could be bothered to do research and answer, namely: if quantitative/mechanical strategies like many of us practice are so great, how come they don’t take over the mutual (not hedge) fund world? (which is a criticism that friends often offer bring up when I tell them how I trade)
It’s clear that to me now that the answer is multi-faceted. Some of these points I already knew or suspected, but others were completely new to me.
As you often say, good stuff!
I’m surprised no one has focused on it, but your approach is what hedge funds do. They search for a statistical edge and then play it. The primary reason hedge funds are so leveraged is that they play edges that are statistically real but minuscule. When leveraged up small edges can make a lot of money — as you frequently point out. You do something similar (but not nearly as leveraged) by using leveraged funds.
First… comment to Peaty:
1) This article is more appropriate for structured product quants, not system developers.
2) ALL market analysis is derived from the past, it’s just a matter of sophistication. Given enough time and resources I could model a MF managers decisions.
3) As for your 1-2% alpha comment, have you ever heard of Ren. Tech.?
4)”…until it doesn’t” again you’re confusing modeling with running a portfolio.
My 2 cents, I think marketability and business models are a large part. It’s like being in an unfamiliar small town and trying to decide between McDonald’s and the local hole-in- the-wall that probably has better food. MCD, crappy food, but good business.. hole in the wall, smells great, but who wants to take that chance. Yes, I agree the whole thing is nauseating and I couldn’t live with myself either. What people want and what they need are not the same.
So I guess the moral of the story is that you can make a lot more money if you dress up like a clown and sell hamburgers.
A naive but as such an ingenious provokative question, I must say. Being in the industri since 95 I must say that everytime I have changed job, all my initial ideas has been killed at the new place. Ideas outside a job does not work when you get inside. Its too much legacy on all places. It’s better for you to do a market plan and start your own business instead of trying to educate the industry.
Anyway, thanks for all good ideas on the blog!
“I just don’t get it” are the famous last words of all mathematicians who take their “models”, “programs” and “systems” to Vegas.
An intelligent human being would never lend their hard earned coin to a science experiement.
There are plenty of GREAT nutual funds. The problem is when you find one and they underperfom for a year or two, you are moving on and that is just about the time theyhave they best year. The fund you moved two was doing well but noe they hit dty spell and the chase continues…I cant imagaine haveing a quant on the phone for a conference and what 80 yr old Grandma Green asks why performance 300 basis point under the bechmakr. Well, maam, our model broke down, we have never seen anything likfr this before…it are repgramming it now and we should be back up in now timr,,,,Grandma Green say that great, I will take my momney and come back when you fix it….
Will never fly with the mainstream…
Here is a wage. 2010- Bill Miller will break the record for best perforance in a singl year for a large fund (if he makes it hrough this year) Think on it.
Justin’s comment above made me chuckle because he falls into the same line of thought that so many commenters and blog responses talked about – embracing the anecdotal, rejecting the empirical, quantitative approaches are inherently risky, etc.
I have a number of responses, but I’ll go with the most simple: take a little time to visit first the independently-audited real-time track record of our programs and then read about some of the concepts I’ve talked about on this blog and their predictive ability over long periods of time.
If you still don’t see at least some value in a quantitative approach, then I wish you the best of luck. I will do my rain dance for a bull market in whatever assets you have chosen to invest, because that’s the only way a middling “traditional” approach is going to provide any value.
michael
“There are plenty of GREAT nutual funds. The problem is when you find one and they underperfom for a year or two, you are moving on and that is just about the time theyhave they best year.”
The problem is that identifying a great mutual fund is almost impossible for the average investor – so they will rely on something like Morningstar which rate based on past performance. There is very little way for the average investor to comb through the endless list of mutual funds and come up with a winner. And even if they do come up with a winner, that winner is unlikely to be sustained over a longer time period, and is still likely to underperform a generic index.
“Well, maam, our model broke down, we have never seen anything likfr this before…it are repgramming it now and we should be back up in now timr,,,,Grandma Green say that great, I will take my momney and come back when you fix it….”
And the explanations of the fundamentally-orient mutual fund manager are any better? “Headwinds. Didn’t shift directions quickly enough.” Blah, blah, blah. Or is it just that such comments are more acceptable because they sound reasonable, where the latter sounds like an issue with Microsoft Windows?
“Will never fly with the mainstream…”
For the most part I agree – the number of people that believe in fundamentals far outweighs any other because that is what is propagated by the financial media.
“Here is a wage. 2010- Bill Miller will break the record for best perforance in a singl year for a large fund (if he makes it hrough this year) Think on it.”
Maybe – but does it make a difference when his knife catching attempts wiped out approximately 70% of the money people had in his fund? Now will people jump back in? Absolutely. For me, that kind of bone-crushing event means there is something really wrong with your overall approach.
Jeff: do you deny my one point that the market systems adjust to measurement, unlike physical systems?* Let’s not lose sight of the forest for the trees, which is a particular temptation for the quantitatively-inclined.
marketsci: You asked the question of why current crop of mutual funds don’t think outside the box. Let’s not confuse answers of “why-status-quo-is” as “why-status-quo-is-optimal.”
If current mutual funds cannot evolve, then new mutual funds must be the ones to displace them. The market history is full of examples where innovation only came through new blood, because the old blood was resistant to change for various reasons (some rational, some irrational).
—
*at scales larger than quantum level.
“You can go short, mutual funds can’t. ”
That’s not true. Ask Ken Heebner. Read his prospectus.
Mutual funds can do a lot of things short of employing extreme leverage
They just choose not to … it is better to be conservative, be like the crowd, and collect rich fees for being index funds by buying 300 stocks.
they dominate 401ks, they dominate the mainstream of america’s money – so why not.
Just like analysts there is little reason to be outside the box.
Fundmymutualfund.com
The reason MF managers don’t outperform is because they are mostly over-glorified salesmen who know diddley about trading. The industry prizes sales, not performance. Plus, take a look at the political affiliations and connections of the large MF firms sometime. You see much collusion around the central idea of losing middle class wealth, for the purpose of helping to usher in the New World Order.
While I am not at all surprised that the MF industry is not interested in quantitative trading techniques , there are other heretofore unexplored avenues that are showing interest in our products. We are presently selling into some of the custodian banks and some of the insurers, as well as the more-likely candidates such as energy traders, global banks, and HFs.
The tide might be changing.
What led me to this conclusion is a quote from a recent (January) report by Bernstein Research:
“… Given the stock market’s persistent volatility, many investors have asked about the efficacy of technical analysis as a way to refine buy and sell decisions or to enhance quantitative strategies. That led us to investigate…”
If this is indeed the beginning of a new trend (MFs using short term quant edges) we might see a shift in the profitability of short term strategies… for better or for worse.