Skill, scale, and value creation in the mutual fund industry
Institutional Communication Service
When investors shop for mutual funds, they typically focus on performance, which is generally measured by the level of returns (compared to a given benchmark). However, far less is known about value creation, i.e. whether funds, or rather the fund managers, are capable of extracting genuine value from capital markets through their investment decisions. Moreover, when investors make their decision, they seldom manage to consider the ability to identify profitable investment ideas (skill) and to manage the fund’s growth over time (scalability), limiting themselves to the traditional measures of size and performance. An empirical study performed by researchers at the Swiss Finance Institute in Lugano and Geneva and at McGill University in Canada, and published in the world-leading Journal of Finance, has identified an alternative approach to fund value creation that focuses on the ability to identify profitable investment ideas (skill) and to grow in size (scalability). Co-author Patrick Gagliardini, Full professor of Econometrics at the USI Institute of Finance, tells us more.
Active funds create value when they trade based on superior information (stock picking, factor timing, etc.), or when they provide liquidity to absorb selling pressure during downtrend phases. In their study, Prof. Gagliardini, Olivier Scaillet (University of Geneva) and Laurent Barras (McGill University), propose an alternative breakdown of the value added in an investment fund. Instead of focusing on size and gross returns, they focus on skill and scalability. First, the researchers quantify how many funds create value and assess whether they do so with more profitable or scalable ideas. Second, they examine whether funds create more value over time as investors learn about skill and scalability. Third, they measure how far the fund value added is from its optimal level determined by skill and scalability. Finally, they examine whether the industry delivers negative returns to investors because it is populated by unskilled funds or by funds that scale their ideas too far.
“Together with my colleagues we have developed a new estimation approach to infer the entire cross-sectional distributions of skill, scalability, and value added in a set of mutual funds we considered”, explains Prof. Gagliardini. “Our results shed new light on the value creation process. By using correlated skill and scale coefficients, we find that the most valuable funds are not those with the best investment ideas. Instead, their investment strategies balance skill and scalability. We observe similar trade-offs among funds with different levels of liquidity and turnover - two key determinants of the fund investment strategy. For instance, small cap funds buy more illiquid stocks, which generate both higher mispricing and trading costs. With this particular combination of skill and scalability, we find that small cap funds create more value than large cap funds. Finally, funds directly sold to investors are more skilled and generate higher value added than broker sold funds”.
The paper Skill, Scale, and Value Creation in the Mutual Fund Industry is available online at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3269995