Swedroe: Cross Trading Boosts Mutual Funds Returns

October 21, 2016

Cross-Trading Distorts Performance
While the authors concluded that “careful regulatory scrutiny seems to be highly effective in limiting both the extent of mispricing and the incentive to cross-trade,” they also acknowledge that their results suggest “that cross-trading activity widens the gap in performance between star and junk funds.”

They also observed that the focus of their analysis was on cross-trading activity. However, cross-trades are only one alternative to trading in open exchanges. For instance, large asset managers increasingly rely on “dark pools” and other opaque trading venues.

The authors write: “Overall, our findings point to potential risks posed by the increasing popularity of unsupervised and less regulated trading.” They also note that, consistent with the hypothesis of preferential treatment, fund families are incentivized to start new funds (including what are called incubator funds) and give other funds preferential treatment, thereby increasing their chances of producing a “star” fund. Along the same lines, research has shown that fund families use allocations to hot IPOs to provide preferential treatment, creating the illusion of management skill.

In our book, “The Incredible Shrinking Alpha,” my co-author, Andrew Berkin, and I present four themes that help explain why the percentage of actively managed funds generating statistically significant alpha has dropped from about 20 percent 20 years ago to about 2 percent today.

Those themes are: academic research is converting what once was alpha into beta, there is a shrinking pool of victims that can be exploited, competition from more skilled fund managers is increasing and there is an increased supply of capital chasing alpha. Eisele, Nefedova and Parise provide us with yet another contributing factor—tougher regulations have reduced the ability of fund families to transfer profits to their “stars.”

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

 

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