A new study supports the anecdotal evidence.
Oddly, hedge funds thrived during the 1990s and the first half of the Aughts, while “hedge fund-like” mutual fund categories did not. There weren’t many such categories, but those that existed—option-income funds, market-neutral funds, short-term multi-market income funds (don’t ask)—performed poorly.
It is true that those glowing hedge-fund results came with an asterisk. Because hedge funds are not required to report their returns to a central authority, they self-report. That is, they give their results to databases when and if it suits them. That naturally leads to both creation and survivorship biases, with hedge funds surfacing when the numbers support them, and then disappearing when they do not.
Nonetheless, while academics found the evidence for hedge-fund performances to be mixed, there’s no question that hedge funds outshone those mutual fund categories that emulated them. Many hedge funds, famously, posted outstanding returns during that decade and a half, whereas the list of mutual funds that succeeded by following complex strategies is, to put the matter kindly, scanty.
This paradox is well known. What has not been addressed, until now, is whether mutual funds’ failure was caused by the categories, or by the tactics themselves. That is, did the problem lie with a faultily constructed category, or was the problem more general? Is adding leverage, using options, and/or shorting unhelpful for most mutual funds, regardless of their investment category?
More is Less?
Per a recent study, it appears to be the latter. In “Use of Leverage, Short Sales, and Options by Mutual Funds,” three faculty members of Queen’s University in Ontario (Paul Calluzzo, Fabio Moneta, and Selim Topaloglu) examine 17 years’ worth of U.S. mutual fund data, and find that, on average, domestic equity funds that use at least one of those three tactics have underperformed their peers.
As you may suspect, some of the shortfall owes to extra cost. The general rule of mutual fund pricing is, the fancier the label, the more that investors pay, and that holds true of the authors’ buckets as well. Those funds that used leverage, short sales, or options at least once during the time period have expense ratios that are 7 basis points (0.07 percentage points) higher than those funds that are permitted such strategies but which abstain, and 19 basis points higher than those funds that are forbidden by prospectus from engaging in such tactics.
(That margin is smaller than I would have guessed, because those funds in the hedge fund-like categories are typically very pricey. The explanation, I think, is that by delving deeply (they examined 101,174 SEC filings!), the authors uncovered many funds that occupy conventional categories—say, large-growth U.S. stock. Those funds use complex strategies to supplement their investment approaches, rather than as their main course.)
Losing by a few basis points because of higher expenses wouldn’t be particularly noble, but it wouldn’t be a disaster, either. The bigger problem is that these funds trail even before costs are considered. The authors compare those funds that use complex strategies to those that are permitted but abstain, and find that usage is correlated with lower returns and higher risk. Neither amount is particularly large (the authors find that using leverage costs 36 basis points per year on average, conducting short sales and buying options costs from 67 to 80 basis points, and that selling options has slight positive benefits), but still, the direction is wrong.