Setting up structures to differentiate alpha-generators and beta-grazers
-------------------------------------------------------------------------------- A paradigm shift in investor behaviour is necessary to enable mutual funds to generate optimal returns. Such a move will give the investor a range of funds to choose from, diversifying risks. -------------------------------------------------------------------------------- B. Venkatesh Several mutual funds are available in each style-class. But as one investor complained, most of the funds in each style-class have similar portfolios. This leaves investors with limited choice to diversify risk. That is, perhaps, why most investors end up with fund diversification rather than portfolio diversification. Mutual funds carry similar portfolios, perhaps, due to the myopic attitude of investors and a revenue structure tied to the assets under management (AUM). This article shows that a paradigm shift in investor behaviour is required to enable mutual funds to generate optimal returns. The asset management firms, for its part, should signal to the investors that they can beat the style benchmarks if they are not penalised for taking active bets. Together, these changes can improve the efficiency of the mutual fund industry. Herding? Take two hypothetical mutual funds, Fund A and Fund B. Both follow no particular investment style but claim to "generate capital appreciation over the long term". Technically, the portfolio of both funds can be as diverse as possible. Yet, both have similar assets. Why? Suppose Fund A has an aggressive portfolio manager who takes exposure to the technology sector. Two states of nature are possible. One, if the technology sector indeed does well, this fund will be an instant winner. Two, if the technology sector underperforms the broad market, the fund will be penalized. The problem is that the portfolio manager does not know ex-ante if her investment theme will prove to be an alpha generator; alpha refers to the excess returns that a portfolio manager generates over the benchmark index. Fund A would trail the benchmark index if its active bets turn wrong. And that would prompt all the myopic investors to switch from Fund A to Fund B, which does not take such aggressive bets. This leads to loss in revenue for the asset management firm that manages Fund A, for the firm charge fees based on AUM. The fear of loss in revenue forces asset management firms not to take aggressive bets. There is another factor at play. Investors' fear that their portfolios will perform poorly compared with their peers. Absolute losses are, hence, not penalized as much as relative losses are. To explain, it is not so much a problem for a fund to lose 15 per cent when peer funds have also lost as much. A fund will be, however, penalized if it loses 5 per cent when peers have generated 10 per cent returns. These factors force funds to herd. Portfolio managers will be greatly benefited if there is a paradigm shift in such investor behaviour. And that can happen if the mutual fund investments are made to fulfil an investment objective or a liability structure. At present, most investors buy mutual fund units to earn returns higher than that on fixed-income securities and not to meet any liability structure. An investment made to fund a liability structure may moderate such needless fund switches. That would take some pressure off the asset management firms, providing leeway for portfolio managers to try new investment themes. An investor may, for instance, buy mutual funds to finance the purchase of a house 5 years hence. The investment objective then is to meet the cost of the house or the liability structure. An underperformance in the fund may not necessary lead to underfunding of the liability structure. Till then, the investor is not compelled to switch to a better performing fund. It would also help if asset management firms adopt exchange-traded interval structure (refer this column dated December 7) instead of an open-end structure. Investors in such funds can at best sell the units in the secondary market and not redeem with the asset management firms. Such a structure allows the portfolio manager to test new alpha-generators without fearing redemption pressure due to short-term underperformance. Asset management firms, for their part, should send strong signals to investors about their alpha-generation skills. One way could be to charge a substantial proportion of the fees based on performance. This sends a signal that the asset management firm and the portfolio manager are confident of their skills and are willing to participate in losses should their active bets turn wrong. When the fund and its manager take ownership for the alpha decisions, investors may be willing to tolerate losses. Conclusion What good can come from such a paradigm shift? For one, mutual funds with same style could have different alpha-generators. That will provide investors with a wide range of funds to choose from and diversify risks. For another, it will differentiate the skilled managers from others. And that could eventually lead to a consolidation in the industry, as alpha-generators wean away AUM from the beta-grazers. (The author is an investment strategist. He can be reached at [email protected]) http://www.thehindubusinessline.com/iw/2008/12/14/stories/2008121450170800.htm Government cannot make man richer, but it can make him poorer --~--~---------~--~----~------------~-------~--~----~ You received this message because you are subscribed to the Google Groups "Kences1" group. 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