Can Mutual Funds become Hedge Funds? No.

Can Mutual Funds become Hedge Funds? No.

September 2, 2014 Research Insights
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(Last Updated On: January 18, 2017)

Investment Restrictions and Fund Performance

Abstract:

We examine why mutual funds appear to underperform hedge funds. Utilizing a unique panel of mutual fund contracts changes, we explore several possible channels, including: alternative investment practices (e.g., short sales and leverage), performance-based compensation, and the ability to restrict the funding risk of fund flows. We document that over our sample period, mutual funds were more likely to shift their contracting environment closer to that of hedge funds. However, this shift provided no benefit to mutual funds and we find no causal link between these contract changes and improvements in performance. Rather, our results cast doubt on the binding nature of investment restrictions in the mutual fund industry.

Alpha Highlight:

The evidence from academic research shows that mutual funds have no gross of fee alpha, but hedge funds, on average, may have gross-0f-fee alpha (the HF database is questionable). There is a lot of debate surrounding these findings, but that is the general takeaway. A natural question academics have asked is, “Why do hedge funds outperform?” One hypothesized advantage for hedge funds is the contracting environment. For example, hedge funds have an ability via the limited partnership structure to lock-up capital, charge performance fees, short-sell, trade exotic contracts, and so forth.

The authors in this paper look at a quasi-natural experiment where mutual funds go from a plain-vanilla operating structure and change their operating environment such that it more resembles a hedge fund.

The authors then test the following hypothesis:

Do mutual fund managers that adopt “hedge-fund-like” features improve performance?

In short, the answer is no. Performance on mutual funds that adopt hedge fund characteristics actually perform the same–and sometimes worse–than they did operating in a plain vanilla environment.

The authors come to the following conclusions:

Our evidence is not consistent with the idea that investment constraints prevent mutual fund managers from performing at the same level as their hedge fund counterparts.

The legal environment in the United States places heavy restrictions on mutual funds that attempt to implement hedge fund strategies…[but] it is unclear why we find no evidence that mutual fund performance improves following the change.

Our results are consistent with a growing body of literature pointing to the fact that mutual fund and hedge fund performance may not be as dissimilar as previously thought.

Here is the key chart from the paper. The “Post” variable is the key variable of interest. A positive value indicates a positive relationship between performance and hedge fund characteristics; a negative value indicates the opposite. The evidence highlights that the contracting environment can’t save the lame-duck nature of mutual fund performance net of fees.

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

What do you think? Time to become a day-trader?


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Definitions of common statistics used in our analysis are available here (towards the bottom)




About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray’s interest in entrepreneurship and behavioral finance led him to found Alpha Architect. Dr. Gray has published three books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army, QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, and DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His numerous published works has been highlighted on CBNC, CNN, NPR, Motley Fool, WSJ Market Watch, CFA Institute, Institutional Investor, and CBS News. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.