Finally, bringing closet indexers out of the closet

In 2009, Martijn Cremers and Antti Petajisto published their paper: “How Active Is Your Fund Manager? A New Measure That Predicts Performance,” in which they unveiled a dirty little secret about the asset management industry. A substantial number of asset managers hold positions in their portfolios that hardly deviate from their benchmarks with low tracking errors, while still claiming to be active. The authors found that not only do these closet indexers charge higher fees than true indexers, but they actually underperform true active managers.

Closet indexers are not just bad for their investors but they also create an adverse selection problem that affects legitimate active managers. It turns out that Sweeden is going to be the first government to do something about it. According to the FT:

Per Bolund, Sweden’s deputy finance minister and minister for capital markets and consumers, confirmed last week that the government would investigate closet trackers, which have been widely criticised by consumer groups and academics for misleading investors.

The FT also informs that

The Danish regulator, Finanstilsynet, launched an investigation into so-called “benchmark-hugging” funds last September and found that almost a third of the 188 domestic equity funds in Denmark could be classified as closet trackers.

This is indeed great news and encouraging for those who believe that financial consumers need to be better served by regulators and supervisors.

Is gender a factor in fund performance?

From the Financial Times.

Fixing the Drain on Retirement Savings

Some striking facts about the perverse long-term impact of high fees on investors’ wealth, from the Center for American Progress.

[…] consider, for example, that a worker has a choice of investing in a mutual fund with a total expense ratio of 25 basis points—0.25 percent, which is in line with available, low-cost retirement options—or another with fees of 100 basis points—1 percent. While the difference of 0.75 percent may sound small mathematically, the cumulative effects over time of that difference are huge.

Assume this worker is 25 years old, earns the median income of $30,502 for workers in her age group, and saves 5 percent of her salary annually in a retirement plan, which in turn is matched by her employer for a 10 percent contribution amount. That seemingly small 0.75 percent difference would cost her almost $100,000 in fees over her lifetime, according to our calculations […]. To make up the difference caused by high fees versus low fees in her account balance by the time she retires, that worker would have to work more than three additional years. This means that saving in a retirement plan with average fees can force a worker to stay in their job years longer than they may have planned.

 

What about a worker in a similar situation earning $75,000 at age 25? Over the course of her lifetime, she would pay more than $300,000 more in fees if she were invested in the fund with 1.3 percent fees compared to the 0.25 percent fee fund. In fact, to make up the shortfall in her account by the time she retires, her total contribution—including both employer and employee contributions—would have to increase by 25 percent. Even worse, since employer contributions generally top out at or below 5 percent, she would likely have to increase her individual contribution to her retirement from 5 percent of her salary to 7.5 percent—a jump of 50 percent in her personal retirement savings each year for her entire working life.

Those calculations assume that portfolio before-fee returns stay the same regardless of the fees charged to investors. But there’s no reason why that would be the case. After all, why would investors be willing to pay higher fees, mostly used to pay for management services, if not for higher performance? Indeed, higher fees wouldn’t be a problem if they were offset by at least commensurately higher returns. However,

When it comes to the fees investors pay to participate in mutual funds—through their retirement accounts or other vehicles—the reality is that investors are not necessarily getting a better return when they pay higher fees.
Economists Javier Gil-Bazo and Pablo Ruiz-Verdú studied this phenomenon in their widely cited 2009 paper “The Relation between Price and Performance in the Mutual Fund Industry.” They actually found that “there is a negative relation between funds’ before-fee performance and the fees they charge to investors.” This paper furthered the 1996 research of NYU Professor Martin Gruber, former president of the American Finance Association, who found that “expenses are not higher for top performing funds.” Gruber also noted that “It has been suggested that management prices excellent performance by charging higher fees.” But “In fact this is not the case.”

How do we fix this? The authors propose more and better disclosure.

The lesson here is that for investors to understand the impact of their choices, more disclosure is not the complete answer. What is required is better disclosure. Currently, some disclosures contain more than 30 pages, overwhelming consumers with detailed information that is difficult to navigate.

Following the advice of our colleague, economist and CAP Senior Fellow Christian Weller, we believe that financial disclosures should be:

• Concise: brief and easy to navigate.
• Accessible: prominently displayed on all retirement fund materials.
• Relevant: highlighting key cost information in a way investors can understand.

You can find my paper here and the full article here.

Master Projects by BGSE Master in Finance Graduates

Every year the Master in Finance students at the BGSE are asked to conduct a research project on a Finance topic. The project enables students to put into practice the knowledge and skills that they have acquired during their Master. The projects presented this year were impressive in terms of technical quality, depth, and importance of their practical implications.

Some of these projects have been featured in the Barcelona GSE Voice blog:

• Too-many-to-fail: a theoretical approach
• Realized Volatility Estimation
• Interest rates after the credit crunch crisis: single versus multiple curve approach

Mutual Fund Strategies and Investor Characteristics

Hang Dong successfully defended his doctoral dissertation at University Carlos III on Mutual Fund Strategies and Investor Characteristics, which I co-supervised with Pablo Ruiz-Verdú. In his thesis, Hang investigates three underexplored issues in the mutual fund literature. First, Hang asks the question: Are there any differences in the way investors with different sociodemographic characteristics make their mutual fund choices? And, what are the consequences for the performance of their portfolios? To answer these questions, Hang uses a novel dataset on internet visits to websites that covers most management companies offering funds in the US. The dataset enables Hang to relate the sociodemographic characteristics of (potential) investors to the characteristics of mutual funds. The results are suggestive of marked differences in the way investors from different sociodemographic backgrounds make portfolio decisions, which in turn, translate into differences in performance.

Second, Hang investigates the strategic decision of the dividend redistribution policy by mutual funds. Since mutual funds in the US must redistribute most of their dividends to fund shareholders in order to avoid paying taxes, the question arises as to how the dividend payment frequency is chosen by mutual funds. Hang hypothesizes that when considering their dividend policy, mutual funds face two trade offs: (1) attracting new investors versus helping existing investors pay less taxes; and (2) attracting a dividend clientele versus avoiding the costs associated with frequent dividend payments. Empirical results support the paper’s hypothesis that mutual funds are strategic about their dividend policies.

Finally, the thesis provides for the first time direct evidence of the existence of dividend clienteles in the market for mutual funds.

Hang will be joining IE University as an Assistant Professor in September. Congratulations!

Financial Literacy and the Efficacy of Financial Education

There is an interesting post in Marginal Revolution on a recent paper by Annamaria Lussardi and Olivia Mitchell, in which they review the existing research on financial literacy. These authors and other researchers have long unveiled a strong correlation between failure to provide correct answers to simple financial questions and wrong decision making in borrowing, saving for retirement, investing, and managing resources during retirement, with large costs for individuals’ wealth.

Improving our knowledge of financial literacy is very necessary not only from an academic point of view but also from a policy point of view. Although, differences in the optimality of financial decision making are not only explained by differences in financial literacy—we know that IQ and proneness to behavioral biases can also explain why some individuals make suboptimal financial decisions–public policies aimed at increasing the level of financial education have a strong potential to reduce the gap between the most vulnerable groups and the rest of society.

However, the scientific evidence of the impact of financial education programs is not conclusive. As Lusardi and Mitchell warn us, studies that evaluate the impact of financial education programs face important challenges:

“if a program were to be judged based on specific behavioral changes such as increasing retirement saving or participation in retirement accounts, it should be recognized that the program is unlikely, both theoretically and practically, to change everyone’s behavior in the same way.”

Moreover, financial education programs carefully designed to test scientifically for the effect of financial education on financial knowledge and decision making are still scarce. For instance, voluntary attendance programs are of little value since those individuals with a larger proclivity to make better financial decisions are also the ones more likely to enroll in financial education programs.  Also, in some of these programs the quality of teaching is not observed.

In Spain, the Securities and Exchange Commission (Comisión Nacional del Mercado de Valores, CNMV) and the Bank of Spain launched a Financial Education Plan in 2008. The Plan includes increasing financial contents in both secondary and college education, as well as the use of publications, workshops, and online contents, targeted to the adult population.  It would be extremely interesting to know more about how the specific education programs have been designed and in particular, whether they have been designed in a way that it is possible to use them to draw inference on the efficacy of financial education.

Transparency in the Asset Management Industry

I recently had the opportunity to participate at the 13th Colloquium on Financial Markets organized by the Centre for Financial Research in Cologne. It was a very interesting experience and I enjoyed it a lot. The program included research papers in Asset Pricing, Market Microstructure, and Asset Management. You may find the program here. In a future post, I will talk about my current research project on institutional trading activity and liquidity, which I presented at the Colloquium. In this post, I would like to summarize a great paper by Simon Gervais (Duke University) and Günter Strobl (Frankfurt School of Finance and Management), which I had the opportunity to discuss. I liked the paper very much and I think it is very necessary to have more theory guiding empirical research in the area of institutional investment.

Foto: Centre for Financial Research Cologne

In their paper, Transparency and Talent Allocation in Money Management, the authors investigate theoretically how different degrees of transparency arise endogenously in a context of competition among asset managers and investors. To do that, they propose a model where transparency can be used to signal quality.

 

The model’s ingredients are the following:

• There are three types of managers: high-skilled, h; medium skilled, m; and low-skilled, ℓ.
• Each manager observes her own type, sets up a fund, and chooses a level of transparency, t, which defines the probability that a ℓ-manager sends a bad signal to investors.
• Transparency increases the fund’s costs.
• Investors observe t and the history of returns each period and invest as long as net expected performance is positive.
• Diseconomies of scale and competition among investors imply that all funds deliver zero net expected performance in equilibrium (Berk and Green, 2004).
• Managers choose fee to maximize compensation.

Under these assumptions, the authors prove that in equilibrium, ℓ-managers and h-managers choose the same level of transparency. Why? ℓ-managers will always want to look like they are better than they really are. However, m-managers will never choose to pool with ℓ-managers and separate themselves from h-managers. A partial pooling equilibrium in which ℓ-managers and h-managers choose the same level of transparency and m-managers choose a different level of transparency exists as long as m-managers are sufficiently more transparent than the other two types and the number of periods is sufficiently large. The intuition for this result is that ℓ-managers do not want to incur the costs associated with the higher transparency of m-managers. Also, m-managers do not want to lower transparency in order to look like h-managers since in the long run, their lower returns will give them away. Finally, h-managers do not want to increase transparency to separate themselves from ℓ-managers, since in the long-run their higher returns will drive investors away from the latter. Therefore, in the partial pooling equilibrium both the most and the least skilled asset managers choose to be more opaque, while the average skilled managers choose to be more transparent.

The paper therefore provides a rationale for the existence of two levels of transparency in the asset management industry: mutual funds, subject to strong disclosure requirements, and hedge funds, which remain largely opaque to investors. Also, a number of new empirical predictions can be obtained from the model, which will provide the basis for future empirical research.

I think it would be interesting to further investigate some extensions in the future. For instance, how would the model’s results change if asset managers could signal their types through other choices, such as the decision to charge a performance-based compensation? How would entry of new funds every period affect the likelihood of the partial pooling equilibrium? What would happen if transparency enabled m-managers to send a signal to investors directly, just like ℓ-managers?

Taking the model to the data is not trivial. For instance, different degrees of transparency could attract investors with different degrees of sophistication, which in turn can impact their performance (see my previous entry). Also, hedge fund databases contain information only on those hedge funds that volunteer that information. Therefore, one would expect that the worst managers will be strategic about disclosing information, so even if hedge funds contain both the best and worst funds of the industry, as the model predicts, the hedge fund databases will be biased towards the best performers. The problem with opacity is that what’s opaque to investors is also opaque to researchers. These are some interesting challenges for empiricists.

The paper won the Best Paper Award at the Colloquium. Congratulations to the authors!