December 2016 IssueLong scroll reading

The three coolest studies of 2016

By David Snowball

There are scholars whose entire lives are consumed by the need to study mutual funds. Not “study” in the carefree way I do or the deeply-tainted way that marketing-driven organizations do, but “study” with considerable rigor, sophisticated tools and a willingness to struggle with complexity.

While much of the content of these studies is inaccessible to most of us,


their conclusions are often provocative, important and ignored. Why ignored? Because folks from large, asset-obsessed organizations don’t want to talk about it and journalists, who mostly need 500 catchy words by this afternoon, can’t talk about it.

Fortunately, the Observer can. Here are three findings, with links back to the originals, that you really need to now about.

Small funds are better than big funds

Javier Vidal-García , “Short-Term Performance and Mutual Fund Size” (June 28, 2016)

What he did: This is scary. Vidal-Garcia and his team looked at the daily returns for 16,000 active equity funds spread across 35 countries over a 25 year span. He wanted to look at the relation between short-term mutual fund performance and fund size around the world.

What he found: “[S]mall funds outperform large funds.” Fund size is negatively related to net returns and to alpha, or returns in excess of a risk-free benchmark. He also found “evidence of a negative fund effect on stock picking ability, which indicates that the smallest funds have superior stock picking skills compared to bigger funds.” That’s true even allowing for the greatest expenses that small funds necessarily bear: “our study suggest that small funds exist and might have great opportunities to prosper. While small funds are not as competitive in terms of expenses as the big funds, they can compensate this disadvantage offering larger average returns.”

What can you do with this? You need to become a bit more independent and a bit more assertive. The research substantiates MFO’s basic claim: your best hope of finding excellent managers who are driven by the desire for excellent performance is to look at small, independent funds. This means giving up the single-minded obsession with expense ratios (sometimes the money is well-spent) and the single-minded obsession with “market-beating returns” (which are bad, bad, bad if the market is in one of its periodic manic fits). It also means finding managers who understand their capacity constraints and have firm, public plans to close the fund to new investors before it’s too late.

Diverse management teams outperform all others

Kian Tan and Anindya Sen, “Do Educational Quality and the Diversity of Managers Matter for the Performance of Team-Managed Funds?” (April 19, 2016)

What they did: Tan and Sen looked at the composition of 3288 mutual fund management teams during the period from 1994 to 2013, which gave them data from both exceptional bull and bear markets. They looked at two elements of each manager’s educational background: the quality of their graduate training and the diversity of their fields of study.

What they found: Tan and Sen found find that the proportion of team members from top MBA programs and the diversity of educational fields within the team have a significant positive effect on fund performance. In particular, strong, diverse teams have greater alpha. A more interesting finding is that, over the long term, diversity of perspectives seems to be more important than high-quality degrees. They conclude, “Our findings also add to the growing body of literature showing a significant positive correlation between informational diversity of teams and performance.” Sadly, they also note that investors haven’t figured this out so that more diverse, higher-quality teams don’t draw more money than other teams do.

You might also enjoy Dr. Tan’s research on Superstar Fund Managers (August 2016) which finds that winning a Morningstar Manager of the Year award drives down subsequent performance because performance-chasing investors flood the winners’ funds, effectively hamstringing them.

What can you do with this? Look for teams with a difference. Engineers, physicists, philosophers and physicians have all become top tier fund managers. Given a choice, choose a team where some members are male and some female, some American and some not, some finance geeks and others … well, other kinds of geeks. And if a liberal arts education is lurking in their background, all the better.

ETFs are bad for your health

Utpal Bhattacharya , Benjamin Loos, Steffen Meyer and  Andreas Hackethal, “Abusing ETFs” (July, 2016)

What they did: Bhattacharya and associates was able to identify and track the behavior of nearly 8000 German investors who had reasonably large portfolios. They looked at two questions: (1) did portfolios with substantial ETF exposure outperform those without and (2) did individual investors’ performance improve once they started adding ETFs to their portfolios.

What they found: It’s pretty stark. “[N]o groups of investors benefit by using ETFs.” They found that timing and trading decisions offered by ETFs drove down a portfolio’s returns (technically, its contingent alpha). It appears that ETFs dropped portfolio returns by 1.1% annually even when they accounted for only a small portion of an investor’s portfolio. At base, investors preferred niche ETFs to broadly-based ones, ETFs encourage trading (that’s the “T” in the name) and most individual damage their portfolios whenever they start trading.

What can you do with this? Do not buy ETFs. If you like low-cost, low-turnover passive investing, buy a broadly-diversified, low-cost, low-turnover index fund. Then leave it alone. Don’t look. Get on with your life. The less you play with it, the better you (and it) are.

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About David Snowball

David Snowball, PhD (Massachusetts). Cofounder, lead writer. David is a Professor of Communication Studies at Augustana College, Rock Island, Illinois, a nationally-recognized college of the liberal arts and sciences, founded in 1860. For a quarter century, David competed in academic debate and coached college debate teams to over 1500 individual victories and 50 tournament championships. When he retired from that research-intensive endeavor, his interest turned to researching fund investing and fund communication strategies. He served as the closing moderator of Brill’s Mutual Funds Interactive (a Forbes “Best of the Web” site), was the Senior Fund Analyst at FundAlarm and author of over 120 fund profiles. David lives in Davenport, Iowa, and spends an amazing amount of time ferrying his son, Will, to baseball tryouts, baseball lessons, baseball practices, baseball games … and social gatherings with young ladies who seem unnervingly interested in him.