May 1 , 2006
Do mutual funds—or their managers—fuel performance?
by diana drake
When it comes to the world of work, mutual fund managers are a respected breed. But are they a dying breed? Klaas Baks, assistant professor of finance at 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 fund managers in recent history, Peter Lynch. When Lynch started managing the Fidelity Magellan Fund in 1978, it had assets of about $20 million; by the time 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 fund’s performance: the manager, because he or she is in charge of the investment decisions; and the fund organization, which can influence performance through administrative procedures, execution efficiency, corporate governance, quality of the analysts, relationships with companies and so on.
Baks set out to separate the manager from the organization to determine just how important the manager truly is.
“There are reasons to believe both are important,” said 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. Most 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 set out to isolate performance by tracking mutual fund managers as they moved from firm to firm, examining their performance with 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 managed 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 change jobs frequently; from 1992–99, a manager of a domestic diversified equity fund worked on average for 3.6 years, managed on average 1.7 funds, stayed at one fund on average 3.1 years, and worked on average for 1.2 management companies.
In the end, few managers beat their benchmarks everywhere they worked. Abnormal performance of a manager varied from fund to fund, suggesting that manager changes, on average, had little impact on abnormal performance.
The second part of Baks’ paper investigates the relative importance of funds and managers for a manager-fund combination’s performance. Baks constructed a model that separates manager and fund inputs, measuring the effect of each fund performance. He found that the fraction of abnormal returns contributed by the fund ranges from approximately 50–90 percent, depending on one’s prior beliefs about the existence of skill among mutual funds. The remaining 10–50 percent is contributed by the manager.
In other words, if a fund’s new manager is half as productive as its previous manager, then that fund only has to be 5–50 percent 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,” Baks said. “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,” said 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,” he said. “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.”
This article first appeared in Knowledge@Emory, and is reprinted with permission.