The Evidence-Based Investor

Active managers and the dangers of desperation

Posted by Robin Powell on June 5, 2017

It’s no secret that active managers have been having a hard time delivering alpha. With fund houses closing and cutting staff, managers, aren’t just fighting for their bonuses any more; they are, quite literally, are fighting for survival.

This, in itself, creates an additional hazard for investors, because the more desperate to outperform managers become, the more likely they are to take on additional risk, as new research from Canada has confirmed.

A paper by three academics at the Smith School of Business at Queen’s University in Ontario illustrates how, as passive funds become harder to beat, active funds are increasingly using sophisticated derivatives, resulting in higher fees and lower performance.

According to the authors, Paul Calluzzo, Fabio Moneta and Selim Topaloglu, 42.5% of U.S. domestic stock funds have used leverage, short sales or options at least once during the past 15 years. Between 1999 and 2015, the percentage of funds that are allowed to use all three has risen from 25.7% to 62.6%.

In theory, these so-called hedging strategies are supposed to shield investors from risk. In fact, though, they often have the opposite effect. To quote the authors: “Although they use the instruments in a manner that decreases the fund’s systematic risk, (these managers) hold portfolios of riskier stocks that offset the insurance capabilities of the complex instruments.”

Funds that used complex investments, the authors found, had a 0.59% decrease in excess return and a 0.072% increase in expenses.

It’s not as if we needed one, but here is yet another excuse to avoid actively managed funds altogether.

 

You can download the paper here:

Use of Leverage, Short Sales and Options by Mutual Funds

Thank you to John Waggoner from Investment News for drawing this study to my attention.

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Robin Powell

A journalist and broadcaster, Robin Powell is a campaigner for positive change in the investing industry. He runs a communications company for the evidence-based investing sector called Regis Media.

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