Like polka dots, some things will never completely go away, but the trend is clear. Mutual funds were codified into law with the Investment Company Act of 1940 and have been a mainstay of the investment community for over 70 years. At the time, they were a cutting edge way to repackage the instruments of the day, stocks and bonds, into a diversified entity with a better risk/return profile than individual securities. Over the past decade, active mutual funds have been losing market share to two competitors; hedge funds on one side and index funds/ETFs on the other.

Performance for active funds is composed of two parts, beta and alpha. The low fees of ETFs mean investors can easily acquire cheap, pure beta exposure and actually outperform most active mutual funds. The alpha component is best harvested by hedge funds due to greater flexibility, a stealthier structure, and a better talent pool. Wedged in the middle of these two alpha and beta vehicles are active mutual funds, which can best be described as expensive beta exposure combined with cheap low quality alpha. The once modern structure has become a beast with two ugly heads that should be banished from every advisors playbook.

Low ETF Fees

Index funds outperform their active fund competitors almost 90% of the time given a 20 year time frame.[i] How is it possible that only 10% of professional managers can beat passive competitors that literally do not even try? Mutual funds compete in highly efficient markets, so to be a part of the esteemed 10% you need lottery winning amounts of luck or top talent.

The S&P 500 SPDR ETF (SPY ) can be purchased with a net expense ratio of .0945% versus a 1.5% expense ratio for most active funds competing against the same benchmark.[ii] The active fund must outperform the index plus the fee differential in order to justify its existence. Anyone buying an active fund over the index fund is playing a game stacked so far against their favor that casinos would blush with envy.

The message is clear: active mutual funds are expensive beta, and their ability to generate alpha is highly questionable. For those who have invested with active mutual funds in the major markets, take a look at some ETFs with a close eye on low expense ratios and tracking errors as SPDR S&P MidCap 400 (MDY ), Vanguard Total Bond Markets ETF (BND ), or Vanguard Small Cap VIPERs ETF (VB ).

Flexibility

Liquidity

Mutual funds must provide daily liquidity and satisfy investor redemption requests within 7 days, compared to hedge funds with no liquidity restrictions.[iii] The liquidity of an asset class is positively correlated with its efficiency, so mutual funds are limited to only highly efficient, competitive asset classes.

Finance is specializing so much that mutual funds are two or even three niches removed from alpha-generating market segments. I recently spoke with a hedge fund with a very profitable entity focused exclusively on trade claims. Trade claims are debt-like instruments found only in the liquidation process of a bankruptcy. Mutual funds may not invest more than 15% of their assets in illiquid securities, so they can barely play in the bankruptcy space at all let alone the absurdly inefficient sub-niche of trade claims.

As the industry broadens to other unique assets such as CDS, CMBS, CDOs, swaps, frontier and emerging markets, and everything else the future of finance may hold, mutual funds will still be stuck with the tools of the 1940s. If mutual funds were architects, they would be the flunky trying to build modern skyscrapers with wooden pegs and 2x4s. Without the proper tools, opportunity to generate alpha is limited.

Leverage

Typically, no more than 33% of a mutual funds assets may be leveraged, including short sales, swaps, options, and other derivatives. The reasoning behind this legislation is that leverage magnifies risk and therefore is unsuitable for the typical retail investor. Leverage is often over-used, however some arbitrage strategies that produce very low returns but also have very low risk profiles can only be profitable with leverage. These strategies emerge when interest rates are low, but mutual funds miss out on these opportunities.

Leverage through derivatives is capped at two times assets, or 100% of NAV.[iv] Derivatives have immense value in risk management but the implied leverage often makes them difficult for mutual funds to implement, leaving them exposed to the whiplash risks of beta.

Hedge Fund Exploitation

Some mutual funds might as well walk through Tripoli at noon wearing a bullseye t-shirt. Mutual fund arbitrage is a game that hedge funds play (and win) by capitalizing on the public rules and positions that mutual funds make available.

- Many mutual funds have a self-imposed rule that they cannot purchase securities below five dollars. Large mutual funds create artificial upward and downward pressure on stocks trading around the $5 range and open up sitting-duck opportunities for competitors.

- A study by Notre Dame showed that hedge funds making predatory trades against known mutual fund positions added an additional .9% in annual alpha to their performance.[v]

- Other regulatory imposed rules prohibit excessive leverage, which means that mutual funds approaching their leverage thresholds are all but guaranteed to liquidate positions.

Imagine trying to coach a football team when you know nothing about the other team, while they know half of the plays you will be running in advance. Protracted moves serve up a zero-sum source of alpha to hedge funds at the direct expense of retail mutual fund investors.

The Talent War

The promise of riches and the allure of the more dynamic alternative investment environment have drawn talent directly into the hedge fund industry at the expense of mutual funds. Beyond the abundance of anecdotal evidence there is some hard data to suggest that hedge funds generate alpha through the talent gap.[vi]

Talent must be compensated, and the higher hedge fund fee structure has been more favorable to top performers. I will note however that the fee gap between hedge funds and active mutual funds is narrowing. In 2010, Prequin released a report that only 38% of single manager funds are still using a 2/20 structure, while the mean fee structure across funds is 1.65/18.89 with the trend heading down.[vii] Despite this convergence, if the hedge fund industry generates more alpha through its inherent advantages and its existing pool of top talent then it will be very difficult for active funds to regain momentum in their recruiting efforts.

The Numbers

The statistics show that active funds are consistently losing assets to index funds and hedge funds. In 1995, ETFs held a paltry .03% share of total assets among public funds. That share increased every single year so that in 2010 ETFs held 7.57% of the mutual fund market, or $1t in assets. The number of ETFs has increased from 80 funds in 2000 to 950 funds in 2010.[viii] As each new index fund offers cheap beta in a different segment of the industry, each active fund in that segment must justify its alpha.

Hedge funds have grown from about $185m in assets in 1995 to roughly $2T in assets today.[ix] The data highlights an alarming consistency of index and alternative asset growth. For the purposes of this article I left out the growth of the private equity and venture structures, but these are other growing alpha-generating structures that will challenge mutual fund assets going forward.

Overall

Active mutual funds are still the weapon of choice for most investors. Their intention is to provide relatively affordable market exposure (beta) and additional returns through manager skill (alpha). We have shown that cheap beta can be bought from index funds and outperform active mutual funds 90% of the time. Hedge funds are superior alpha generators due to their flexibility, their ability to fleece mutual funds through structural arbitrage, and their talent advantage.

Why Do Active Funds Still Exist?

This article begs the question why do active mutual funds still exist? My opinion on this will be the basis of another piece, but my three key reasons in order are:

1. The tedious nature of investing in hedge funds has slowed the rise of the asset class.

2. Active mutual funds are available to retail investors, whereas hedge funds are not.

3. Index funds are a budding industry that has not fully matured.

To the first point about the hedge-fund investment process, SEI reported this year that transparency is the #1 concern of over 70% of institutional hedge fund investors.[x] The process of sourcing and investing in hedge funds is non-uniform and murky. Combining these inefficiencies with the fears of a post-Madoff world, asset flows into hedge funds will continue to be slow unless efficiencies in the process emerge to provide transparency and comfort. The demand is there, as nearly 90% of institutional investors want to either increase or maintain their exposure to hedge funds going forward, but the supply has been slow moving.[xi]

To the second point, active mutual funds will continue to be the second-rate and only option for retail investors until either the hedge fund industry can clean itself up or the regulators do it for them. To the latter point, if the regulators do step in, they will likely crush the alpha-generating opportunities of hedge funds over time and leave them just as sterile as mutual funds.

Thank you for reading and I welcome your thoughts on the abo ve.

References

[i] Thomas P. McGuigan, The Difficulty of Selecting Superior Mutual Fund Performance, Journal of Financial Planning,February 2006.