Sunday, January 21, 2007

Mutual Funds UnderPerform - Agency Issues?

A study entitled Economies of Scale, Lack of Skill or Misalignment of Interest? A Study on Pension and Mutual Fund Performance by R. Bauer, R. Frehenc, H. Lumb and R. Ottenc implies that agency conflicts of interest may account for the fact that mutual funds were found to significantly underperform retirement plan investments. This study concludes that:

  • DB and DC pension fund investment net returns were nominally less, though substantively similar to the performance of their benchmarks,
  • mutual funds underperformed their benchmarks by at least 150 to 200 basis points per year,
  • index mutual funds posted the smallest under-performance, around 50 basis points,
  • mutual fund returns exhibited modest persistency in returns while pension funds exhibited none,
  • mutual fund underperformance relative to pension funds was larger than could be attributed to their differences in cost, risk or style leading to the study's conclusion that a misalignment of interests between mutual fund companies and their investors was responsible .

It was unclear why DC equity returns were comparable with DB equity returns when about 50% of DC assets, at least in the US are in mutual funds. Several possible reasons:

  • DC average equity in the study was $617 million, indicating a higher probability that the DC equity was managed via unitized separate accounts
  • Research indicates DC plans have better access to and generally utilize "better" mutual funds than the mutal fund average,
  • Index fund representation may be higher proportionally in DC plan universes than in mutual fund averages due to fiduciary standards,
  • statistically, any active selection process, even naive performance chasing avoids mutual fund "perma-dogs" which are contained in mutual fund averages.


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