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 Based on the evidence of a new study, which looked at a U.S. genre
of funds called Unit Investment Trusts, investors might want to stop
searching for the next genius fund manager.
Active fund managers can earn their keep in a variety of ways,
including through risk management, skill in execution, skill in
picking sectors, skill in allocating across assets and skill in
translating macro analysis into all of the preceding.
For the vast majority of active equity funds, however, stock
selection is the foundation of how they attempt to outperform.
UITs, which have grown in popularity in recent years, offer a unique
way to measure pure stock selection skill. UITs are SEC-registered
funds which purchase and hold static portfolios for a preset period
of time, eventually being liquidated and distributed at the end of
their planned life. Investors can redeem their units through the
trust sponsor.
Unlike mutual funds, which must keep cash on hand to meet
redemptions, UITs are almost fully invested. That means they suffer
very little 'cash drag,' which has been an explanation put forward
for mutual fund underperformance of benchmarks.
UITs also do not trade, depending entirely on stock selection at the
outset to generate performance compared to benchmarks. Their
advantages also include tax efficiency and the low costs stemming
from the lack of trading.
Earlier studies of mutual fund managers have shown some evidence of
skill, though not enough to outweigh costs. But because of other
issues, like cost and trading, it is harder to get a sense of how
good professional active investors actually are at stock picking.
So a new study by George Comer of Georgetown University and Javier
Rodriguez of University of Puerto Rico is timely, though the news is
not good. (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2608196)
STARTING OUT AS YOU MEAN TO GO ON
Looking at 1,487 UITs which came into existence and matured between
2004 and 2013, the authors find the trusts displayed consistent
negative alpha, or underperformance, despite the study cutting the
data in numerous ways and using numerous benchmarks.
The UITs generated negative alpha of between -2.5 and -2.8
percentage points, with more than 65 percent of all UITs in negative
territory. And all of this is despite the UITs having a modest
23-basis-point annual expense ratio. In other words, if active
mutual funds are underperforming it is not simply because they
create a drag on returns by trading too much. It should be noted
that the UITs studied were not cheap products, carrying an average
of more than 3 percent in upfront sales charges.
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UITs started out by doing badly, and kept it up pretty much all the
way until they were liquidated.
“We find that performance is negative and significant for the first
quarter of the trusts’ life. Performance does improve over the
remainder of the trust life, but it is still negative and
significant,” the authors write.
Taking a broad view, the conclusion is hard to escape:
“Overall, these results suggest that the poor risk-adjusted
performance of our UIT sample reflects poor stock selection skills
by the trusts.”
The trusts studied also lagged similar mutual funds, so we can
conclude that forcing full investment and limiting trading costs is
not a sufficient advantage to start generating real outperformance.
Defenders of active fund managers will at this point be angrily
insisting that UITs, because they don’t trade, are not a fair way to
evaluate the entire active fund management industry. Trading in and
out, running cash balances in order to nimbly take advantage of
opportunities as they arise, all of these are part and parcel of how
active funds try to compete.
True enough, but looking at UITs does give us a more pure window
into stock selection skill.
Based on this study, and what we know from earlier ones of mutual
fund managers, investors in actively managed strategies should not
be hopeful that they will outperform, and less so that
outperformance will happen because of superior stock selection
skill.
That’s a big part of the puzzle, and the outlines are not looking
hopeful for active management.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be an
owner indirectly as an investor in a fund. You can email him at
jamessaft@jamessaft.com and find more columns at
http://blogs.reuters.com/james-saft)
(James Saft is a Reuters columnist. The opinions expressed are
his own)
(Editing by James Dalgleish)
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