The mutual funds are the most important part of the U.S. equity market. The institutional investors hold about two-third of total U.S. equity, and the largest portion of them is mutual funds. They grow almost double in value in recent decay, to the enormous amount, about US$ 27.7 trillion. I review some interesting research that may help the fund industry to be a better fund.
“Know the passive index funds”. The ETFs thrive in the recent decade. Most of them concentrate on “the big three”. They have tremendous power over corporate governance but rarely use it because of their passive nature. If the whole market turning passive, it will gain 0.67% more annually by reducing searching costs. They also become a popular choice when the actively managed funds that decide to park their assets.
However, ETFs led to high comovement for their constituent stocks by providing an easy way to invest in style or industry. They also introduce a new source of
volatility by index arbitrage. They decrease the price efficiency because they crowd out uninformed investors and stock outstanding in the long run, but increase
efficiency in the short run especially for illiquid stocks. Additionally, market indexes in other countries move with the S&P 500 when they close.
“Know the actively managed funds”. I discuss hedge fund is like “mutual fund on steroid”. They target high-net-worth and institutional customers, very low regulation, and heavy rewards for managers. No wonder they attract most skillful managers and perform better than mutual funds.
The mutual funds have liquidity regulation, make most of them behave
momentum trading strategy. They sometimes have to fire sale in the crisis, like selling corporate bonds when securitize bonds become “toxic”. On the other hand, hedge funds are contrarian, using the chance to pick undervalued stocks and profit from it.
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Lock-up hedge funds have even less pressure to provide liquidity thus have a higher premium.
“Know the best”. On average, funds on average seem does not generate positive alpha. Some challenge traditional alpha is not a good measurement, we should use value-added instead. Also, the commonly used quarterly data is overlooking round-trip investment and lead to underestimating their performance, high-frequency data will be better. Using average to represent the whole fund industry is not fair. Multiple pieces of research find they are skill discrepancy between funds can lead to up to 7%
performance difference annually. The skill of funds is consistent up to ten years, and we can only distinguish skills especially in the recession.
Different market cycles are suitable for different skills. In the boom, skilled mutual funds show better stock-picking skill and hedge funds using technical analysis perform well. In the recession, skilled mutual funds show better stock-timing skill and hedge funds fundamental analysis perform well.
The speed and knowledge is power. Investors will learn from the academy to utilize newly found risk factors. And reaction speed for the regular investors is five to sixty minutes, to HFTs less than 200 milliseconds. Some research even finds evidence for information leakage.
“Know your managers”. The characteristic of good managers may graduate from a good university, but not essentially in the Ivy League. Graduate from STEM will outperform their business degree peers in the long run. And being young seems not important than work in a young fund. And maybe is good to have a brave personality.
The managers are not omniscient, they have limited attention. They track a few insiders and have higher performance than untracked ones. But during busy
announcement season or even during their own marriage or divorce, they are distracted and therefore performance suffered.
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“Know your customers” retail investors may just aware non-rational signals like past absolute returns, and often overlook the fees. Institutional investors, on the other hand, care more about the risk-adjust return, Jensen’s alpha, and performance relative to benchmarks.
Retail investors their non-rational behavior may be exploited by funds. Those behavioral biases may have rooted in our genes and IQ. But they can be reduced by financial knowledge and education. Broker-sold funds are expensive and perform worse than direct-sold funds shows possible agency problems. Even firms or funds may be exploited by other institutional investors. Their lending or huge trade information may leak and used by other investors.
“Know the future.” I discuss the modernization of funds. Regarding quant funds, there is no significant difference in performance, but they have less exposure to risk factors than traditional funds. For sentiment analysis, they find daily sentiment has about two days of momentum. Good news influence about two weeks, but bad news can persist a quarter. For HFT, their profit link to relative latency, and the competition is more brutal each year.
“Truth is stranger than fiction, but it is because fiction is obliged to stick to possibilities; Truth isn't.” - Mark Twain. The truth in the financial world is much weirder than the fundamental theories from textbooks. The complex and
ever-changing nature of human society makes these new researches very important to read.
The new technology will be interesting topics for funds, such as neutral language processing, big data mining, artificial intelligence, and blockchain. The evolution of the financial world during the COVID‑19 pandemic is also very interesting. We will expect to see exciting paradigm-changing development for the fund industry in the near future.
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