Diane Del Guercio and Jonathan Reuter
Mutual Fund Performance and the Incentive to Generate Alpha
Journal of Finance | Volume 69, Issue 4 (Aug 2014), 1673–1704

The underperformance of the average actively managed mutual fund has been documented in numerous academic studies, and reported on regularly in investor-oriented publications, such as Forbes and the Wall Street Journal. Because this finding implies that investors are unable to earn back all of the fees they pay to mutual funds for active management, personal finance articles and American Finance Association presidential addresses alike have concluded that investors would be better off investing in passive index funds (French, JF 2008). The fact that the actively managed fund industry continues to thrive despite this persistent underperformance is a long-standing puzzle that several researchers have sought to explain.

Martin Gruber's American Finance Association presidential address first highlighted the puzzle of active management (Gruber, JF 1996). He conjectured that it might be driven by “disadvantaged” investors who are either ignorant of the average underperformance or behaving irrationally. Several recent studies posit that investors might rationally favor actively managed funds because they provide a form of insurance during recessionary times. Under this explanation, investors accept average underperformance in order to benefit from outperformance during periods when they would value it the most, when market returns are poor (Glode, JFE 2011).

In our paper, we propose an explanation related to Gruber's disadvantaged investor hypothesis. Namely, we show that the majority of actively managed funds are sold through brokers, and that investor flow within this segment of the fund industry responds to raw but not risk-adjusted returns (alpha). Because broker-sold fund investors do not reward high-alpha funds with additional investment dollars, broker-sold funds have little incentive to generate alpha. As a result, the underperformance of the average mutual fund in pooled samples is driven by this segment of broker-sold funds. At the same time, funds in the other retail fund segment conform quite closely to what theory would predict. Self-directed investors reward high-alpha funds, which incentivizes asset managers to generate alpha. Importantly, we find no evidence of average underperformance in this segment and thus no puzzle of active management. This implies that the underperformance of the average actively managed fund tells us more about manager and broker incentives than it does about market efficiency.

Many of our insights into this puzzle emerge from an ability to empirically distinguish between retail mutual funds directed at two distinct groups of investors: self-directed investors who are comfortable making their own investment allocation decisions, and those who require the advice of a broker in order to select a fund. This is important because we show that the mutual fund industry is largely segmented along these lines. Fund families that offer their retail funds direct to investors tend not to distribute any of their funds through brokers. Similarly, fund families that sell their funds through brokers tend not to allow investors to purchase funds direct from the family. For example, investors who wish to buy one of the largest funds, the Investment Company of America fund offered by the American Funds family, can only do so through a registered financial advisor. Under this type of segmentation, fund families can tailor their products and their marketing and operational strategies to cater to the needs of their distinct clientele.

Do direct-sold funds face a stronger incentive to generate alpha?

It has long been recognized that fund families have a strong incentive to increase assets under management since funds primarily charge fees that are a percentage of assets. Thus, families are incentivized to deliver funds with whatever product features will ultimately generate more dollar flow into their funds. We show that differences in investor preferences and expertise in the two segments has important implications for the nature of competition for flow within each segment.

According to two surveys, investors who rely on the advice of their broker report that they are not comfortable making their own allocation decisions. They tend to be inexperienced investors who highly value the face-to-face contact and repeated interaction with a trusted advisor. In contrast, surveyed investors who do not purchase mutual funds through a financial adviser state that they “want to be in control of own investments” and already “have access to all of the resources needed to invest on my own”. Furthermore, several papers have documented that commissions paid to brokers provide powerful incentives to direct flow to those products, suggesting that broker-sold funds can better compete for assets through larger payments to brokers rather than through increased efforts toward improving fund performance. For these reasons, we predict that investor flows in the broker-sold segment are less sensitive to alpha than in the direct-sold segment. We find strong empirical support for this prediction.

1: Monthly Flow — Performance Sensitivity Across Market Segments, Actively Managed Funds (1993 to 2004)
Dependent Variable: Net Flow (t) Net Flow (t)
Sample: Both Segments Direct-Sold Broker-Sold
Net flow (t-1) 0.206** 0.189** 0.229**
(0.033) (0.048) (0.026)
Net return (t-1) 0.077** 0.050 0.135**
(0.034) (0.045) (0.023)
Four-factor alpha (t-1) 0.107** 0.176** 0.021
(0.032) (0.049) (0.020)
R2 0.0784 0.0887
The dependent variable is monthly net percentage fund flow, using the standard definition of flow, growth in the fund's Total Net Assets less capital appreciation. The sample size is 122,111.

In Table 1, we report the results of a standard method testing for which fund characteristics are the main drivers of investor flow. We report the results of a regression with fund flow as the dependent variable and two measures of past performance, last period's four-factor alpha and last period's raw return unadjusted for any risk, as the main explanatory variables of interest. We also include in the regression other standard fund-level control variables, such as fund size and expense ratio, but do not report these in the table. Column 1 contains the regression coefficients for the pooled sample that includes funds from both segments, and columns 2 and 3 contain the coefficients for regressions run separately on direct-sold-only and broker-sold-only funds. The key finding is that alpha is a significant driver of flow only in the direct-sold segment, while raw return is a driver of flow only in the broker-sold segment. This suggests that only direct-sold funds are rewarded with more flow when they are able to generate alpha. Broker-sold investor flows do not respond to alpha. The important implication is that only direct-sold funds have an incentive to invest resources in the skilled managers, analysts, and trading desk personnel who will ultimately generate alpha. Note that we were only able to uncover these incentive differences by allowing flow-performance relations to vary across the two market segments. Standard pooled regressions like those in column 1 erroneously suggest that flow into the typical retail mutual fund responds to both raw and risk-adjusted returns.

Do direct-sold funds respond to their stronger incentive?

Although we cannot directly observe whether direct-sold funds invest more resources into the inputs that will generate alpha, we can test whether there are significant differences in the outcomes of such efforts. To show this, we test whether actively-managed direct-sold funds have better measures of value-added performance than actively-managed broker-sold funds. Because the investment universe of small-cap stocks is expected to be less efficient and therefore has greater room for a skilled fund manager to profit, we also separately examine small-cap funds within each segment. Figure 1 summarizes our findings for two of the measures we report in Del Guercio-Reuter (JF 2014): the four-factor alpha of Carhart (JF 1997) and the return gap measure of Kacperczyk-Sialm-Zheng (RFS 2008). The latter measure is designed to capture unobservable aspects of a fund's performance, such as whether trade executions are poor or stellar or whether the fund manager timed their stock purchases or sales well. In regressions controlling for many fund characteristics, we find that the average four-factor alpha of direct-sold funds is 9.6 basis points per month higher relative to broker-sold funds when we consider all equity funds, and 17.4 basis points per month higher when we restrict the sample to small-cap funds. Similarly, we find that the return gap measure is 6.1 basis points per month higher performance for direct-sold funds when we consider all equity funds, and 12 basis points per month higher for small-cap funds. Additional tests reveal that direct-sold families are more likely to make operational decisions associated with higher fund returns. For example, they offer a narrower range of fund styles and rely less on subadvisors than broker-sold families. In sum, we find that direct-sold families internalize the preferences of their target clientele for alpha.

1: Difference in Performance: Direct-sold vs. Broker-sold funds (in basis points per month)
Direct-sold funds performed better than broker-sold funds.

No puzzle of active management in the direct-sold segment

Finally, we show that the puzzle of active management is confined to the broker-sold (disadvantaged investor) segment of the fund industry.

Table 2 shows the results of tests for whether index funds outperform actively-managed funds, or equivalently, have higher alpha. In column 1, we pool all funds together. Index funds perform better than actively managed funds. However, examining the two segments separately reveals that this underperformance is driven by the broker-sold segment, where index funds outperform active funds by 1.12% per year! In contrast, there is no statistical or economically meaningful difference between the performance of the average direct-sold index fund and the average direct-sold actively managed fund. Because there is no underperformance, there is no puzzle of active management within the direct-sold segment; managers are able to earn high enough abnormal returns to justify their fees. This finding conforms to theoretical arguments in Grossman-Stiglitz (AER 1980) and Berk-Green (JPE 2004), and undercuts claims that the U.S. equity market is too efficient for active managers to earn back their fees.

Our findings suggest that in order to better understand the demand for underperforming active management we need to better understand the continued demand for broker services. One possibility is that brokers provide other valuable services to their clients that compensate for the underperformance, for example, by helping them avoid other costly mistakes. Another possibility, however, is that brokers direct clients to the funds that offer them the greatest commission payments, and that their inexperienced clients are unable to distinguish good advice from bad. The fact that we find the overwhelming majority of assets in the broker-sold segment are invested in actively managed funds is suggestive of an agency conflict, but further research is needed to provide a definitive answer.

2: Monthly Fund Four-Factor Alphas of Actively Managed and Index Funds Across Market Segments (1993 to 2004)
Dependent Variable: Four-Factor Alpha (t)
(1) (2) (3)
Sample: Both Segments Direct-Sold Broker-Sold
Index fund dummy (t) 0.073**
Active fund dummy (t) Omitted
Direct-sold dummy (t) × Index fund (t) 0.018
Direct-sold dummy (t) × Active fund (t) Omitted
Broker-sold dummy (t) × Index fund (t) 0.093
Broker-sold dummy (t) × Active fund (t) Omitted
Sample size 122,833 51,469 71,364
R2 0.1135 0.0974 0.1458
Investors are better off in index funds, as the average index fund outperforms an otherwise similar actively-managed fund by 7.3 basis points per month (0.88% per year). This is driven by the broker-sold segment. Standard errors are in parentheses.