The dynamics of mutual funds, analyst expectations, and alphas

In a new paper researchers show that actual expectations of future fund performance can help to explain the active fund industry’s size and its poor performance.

Magnus Dahlquist, Professor at the Stockholm School of Economics and Swedish House of Finance, Markus Ibert, Economist at the Federal Reserve Board of Governors, and Felix Wilke, PhD student at the Stockholm School of Economics and Swedish House of Finance investigate how Morningstar's professional analysts for mutual funds form their expectations of future fund performance. How much do analysts rely on past performance, fund size and fees, and other variables such as a manager's personal investments in the fund and a manager's tenure? Markus Ibert explains why we should be paying attention.

 

Why is this relevant?

– Researchers have been perplexed for a while by the size of the active fund industry despite its poor performance. While in recent years passive funds have increased their market share, the majority of money is still actively managed. While there are several explanations that can help explain the industry’s size and performance, in this paper we propose an intriguingly simple explanation based on a bias in analysts’ expectations.

 

We find evidence that, all else equal, analysts expect active fund returns to increase with fund size, whereas actual fund returns decrease with size. Such misunderstandings of returns to scale in active management can help to explain the industry’s size and performance. If analysts’ expectations are representative of the broader set of investors, then, naturally, many funds are too large because investors believe that funds will perform better the larger they are and underperform because funds do not perform better, but worse, the larger they are.

 

Why do fund returns decrease with fund size?

– The reason is, ultimately, liquidity constraints. The larger you are, the more price impact you have when buying and selling assets, which will erode your profits.

 

Note that this is a causal statement that does not necessarily imply that larger funds in general underperform smaller funds. What we mean by actual fund returns decreasing with fund size is that, all else equal, giving a fund another dollar to manage will decrease its performance.  

 

What impact does analyst ratings have on fund flows? 

– The better the analyst rating of a fund, the more fund flows it attracts, suggesting that analysts' expectations are at least partly representative of the broader set of investors. This result is in line with many other studies showing that investors respond to easy-to-follow recommendations and it holds up even for two different funds that have the same Morningstar Star Rating, which is another popular rating, and which is, in contrast to the analyst ratings entirely based on past performance.

 

We also believe that the ability to test for investors' response to ratings via fund flows makes our setting quite unique to study expectations in general. Typically, other studies simply assume that analysts' expectations are representative, but cannot test for it. 

 

How can we use your conclusions to improve performance on the active fund market? 

– Quite simply, by raising awareness that as a given fund grows larger, it will be more difficult for the fund to outperform. If investors take such decreasing returns to scale into account, they will allocate less capital to the fund, which will improve its future performance. In the end, however, we should not expect active funds to outperform passive funds by large margins: if they were to, investors should chase these opportunities and allocate more capital to these funds, which in turn would erode a fund's outperformance due to decreasing returns to scale in actual fund returns.