In a recent article, I discussed the findings from a study by Brad Barber, Xing Huang and Terrance Odean, “Which Factors Matter to Investors? Evidence from Mutual Fund Flows,” which appeared in the October 2016 issue of The Review of Financial Studies.
In their paper, the authors investigated whether investors tend to consider common equity factors when assessing mutual fund managers. In other words, do investors attempting to identify a skilled active manager strip out the returns that can be traced to a mutual fund’s exposure to the investment factors known to explain cross-sectional equity returns?
In a perfectly rational world, fund flows should only respond to alpha, and not what is simply beta (loading on, or exposure to, a factor). They found, however, that the single-factor capital asset pricing model (CAPM), with market beta as its sole explanatory factor, did the best job of predicting fund-flow relations.
Market Risk Correlation To Fund Flows
This result implies that investors primarily tend to consider mutual funds’ market risk when evaluating performance, and that it is positively correlated with fund flows. The authors found that while investors do not completely ignore other factors that affect fund performance, they place less emphasis on the size and value factors than they do on market risk. In addition, they found no evidence that investors pay attention to the momentum factor.
Interestingly, Barber, Huang and Odean also found that investors who buy mutual funds from the broker-sold channel respond more to factor-related returns than investors buying in the direct-sold channel. This means that investors in the former channel are likely attributing returns to fund managers’ skill rather than to the factors that are responsible for the returns. The results are consistent with the notion that investors in the broker-sold channel are less sophisticated in their assessment of fund performance than investors in the direct-sold channel.
Furthermore, the authors found that investors buying in the direct-sold channel, as well as wealthier investors (more sophisticated investors), use more sophisticated models to assess fund managers’ skill, taking into account a fund’s exposure to factors (such as size and value) rather than attributing the excess returns to manager skill.
‘Unaware Of Other Factors That Drive Returns’
Barber, Huang and Odean concluded: “Our empirical analysis has revealed that investors behave as if they are concerned about market risk, but are largely unaware of other factors that drive equity returns. We have found some evidence that investors attend to the value, size, and industry tilts of a fund when assessing managerial skill, but these effects are much weaker than those we observed for a fund’s beta. Moreover, we have found that investors strongly respond to the factor-related return associated with a fund’s Morningstar-style category. Since the category-level return is not under the control of the manager, this result suggests some mutual fund investors confuse a fund’s category-level performance and manager skill.”
The authors also observed that, when evaluating a fund, investors must first know the factor-related return in order to adjust for it. They write: “Sophisticated investors will seek out this information. But less sophisticated investors may not be aware of size, value, momentum, or industry returns. The market’s performance, however, is ubiquitously reported. This may be one reason why investors do pay attention to market risk when evaluating mutual fund managers.”
How Hedge Fund Investors Judge Performance
Thanks to Jesse Blocher and Marat Molyboga, authors of the October 2016 study “The Revealed Preference of Sophisticated Investors,” we now have an insight into how hedge fund investors evaluate performance. Supposedly, these are more sophisticated investors. What they are for certain is wealthier—which does not necessarily imply greater sophistication. Perhaps surprisingly, they found that “hedge fund investors’ revealed preferences are also best modeled by the CAPM.”
Blocher and Molyboga add: “This finding is surprising, given the diversity of risk faced by hedge fund investors and the well-documented failure of the CAPM to price the cross-section of assets.”
The authors cautioned their results didn’t show that the CAPM fits the data very well. Rather, they demonstrated the CAPM fits the data better than all of the other candidate multifactor models proposed thus far in the literature. Thus, much of investor behavior remains unexplained.
The bottom line is that the evidence from both studies shows that, in general, both mutual fund and hedge fund investors are ignoring the large body of evidence that factors beyond market beta have explanatory power in the cross section of returns.
Thus, they end up attributing to skill what is really nothing more than exposure to common factors, exposure that can be obtained far more cheaply through low-cost index mutual funds and ETFs.
Fortunately, today investors can determine the risk-adjusted alpha of any mutual fund, whether active or passive, simply by using the multifactor regression tool available for free at Portfolio Visualizer.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.