Morningstar Magazine - August/September 2017 - 12

Dispatches

Keep It Simple, and
Keep It Cheap
A new study bolsters the
old argument for
plain-vanilla investing.
IVORY TOWERS

John Rekenthaler

Hedge funds thrived during the 1990s and the
first half of the aughts, but "hedge fund-like"
mutual fund categories were pale imitations. There
weren't many such categories, but those
that existed-option-income funds, market-neutral
funds, short-term multimarket income funds
(don't ask)-performed poorly.
It is true that those glowing hedge fund results
came with an asterisk. Because hedge funds
are not required to report their returns to a central
authority, they self-report. That is, they give
their results to databases when and if it suits them.
That naturally leads to both creation and
survivorship biases, with hedge funds surfacing
when the numbers support them, and then
disappearing when they do not.
Nonetheless, while academics found the evidence
for hedge fund performances to be mixed, there's
no question that hedge funds outshone those
mutual fund categories that emulated them. Many
hedge funds, famously, posted outstanding
returns during that decade and a half, whereas
the list of mutual funds that succeeded by
following complex strategies is, to put the matter
kindly, scanty.
This paradox is well-known. What has not been
addressed, until now, is whether mutual
funds' failure was caused by the categories, or
by the tactics themselves. That is, did the

problem lie with a faultily constructed category,
or was the problem more general? Is adding
leverage, using options, and shorting unhelpful
for most mutual funds, regardless of their
investment category?
More Is Less?
Per a recent study, it appears to be the latter.
In "Use of Leverage, Short Sales, and Options by
Mutual Funds," three faculty members at
the Smith School of Business at Queen's University
in Ontario (Paul Calluzzo, Fabio Moneta, and
Selim Topaloglu) examine 17 years' worth of U.S.
mutual fund data and find that, on average,
domestic-equity funds that use at least one of those
three tactics have underperformed their peers.

As you may suspect, some of the shortfall
owes to extra cost. The general rule of mutual fund
pricing is, the fancier the label, the more that
investors pay, and that holds true of the authors'
buckets as well. Those funds that used leverage,
short sales, or options at least once during
the time period have expense ratios that are seven
basis points (0.07 percentage points) higher than
those funds that are permitted such strategies but
which abstain, and 19 basis points higher
than those funds that are forbidden by prospectus
from engaging in such tactics.
That margin is smaller than I would have guessed,
because those funds in the hedge fund-like
categories are typically very pricey. The explanation,
I think, is that by delving deeply (they examined
101,174 SEC filings!), the authors uncovered many
funds that occupy conventional categories-
say, large-growth U.S. stock. Those funds use
complex strategies to supplement their investment
approaches, rather than as their main course.
Losing by a few basis points because of higher
expenses wouldn't be particularly noble,
but it wouldn't be a disaster, either. The bigger
problem is that these funds trail even before costs
are considered. The authors compare those
funds that use complex strategies to those that are
permitted but abstain and find that usage
is correlated with lower returns and higher risk.

1 Cremers, M. and A. Petajisto. 2006. "How Active Is Your Fund Manager? A New Measure That Predicts Performance." March 21.

Morningstar August/September 2017

Neither amount is particularly large (the
authors find that using leverage costs 36 basis
points per year on average, conducting short sales
and buying options cost from 67 to 80 basis
points, and that selling options has slight positive
benefits), but still, the direction is wrong.
Caveat Emptor
It is at this point that I must issue the usual caveat
for mutual fund research that consumes
massive amounts of data: The dangers are great!
Such studies cannot possibly account for all
explanatory factors. To cite the simplest and most
perilous of items, the funds' categories won't
match. Inevitably, some categories will post higher
average alphas than other categories; that
mismatch affects the results.

That very issue affected the conclusions of the
original Active Share research,1 which purported
to find that funds with high Active Share
scores-meaning that they diverged significantly
from their benchmarks-had better future
performance. It turned out that such funds were
also likelier to be from small-company categories
and that small-company categories fared better
in the authors' performance test. So, that
study contained a hidden small-company effect.
In this study, the authors took some additional
steps to prevent such an occurrence, but it's tricky
to capture all category effects.
Despite the authors' thoroughness, this subject-
as the authors themselves would admit-
resists a firm, irrevocable conclusion. However,
their finding that complex strategies tend
to harm rather than help mutual fund
performances certainly matches the eye test. The
study buttresses the argument that mutual
fund managers who invest in flavors other than
plain-vanilla have some proving to do. The odds
do not look to be in their favor.
Problem Solved
As for the initial puzzle, why complex strategies
work for hedge funds but apparently not for
mutual funds, I think I can answer that. Complex
strategies did boost hedge funds when that

Table of Contents for the Digital Edition of Morningstar Magazine - August/September 2017