How efficiently do mutual funds capture factor premiums? In their April 2017 paper entitled “The Incredible Shrinking Factor Return”, Robert Arnott, Vitali Kalesnik and Lillian Wu investigate whether factor tilts employed by mutual fund managers deliver the alpha found in empirical research. They focus on four factors most widely used by mutual fund managers: market, size, value and momentum. They note that ideal long-short portfolios used to compute factor returns ignore costs associated with real-world implementation: trading costs and commissions, missed trades, illiquidity, management fees, borrowing costs for the short side and inability to short some stocks. Portfolio returns also ignore bias associated with data snooping in factor discovery and market adaptation to published research. They focus on U.S. long-only equity mutual funds, but also consider similar international funds. They apply a two-stage regression first to identify fund factor exposures and then to measure performance shortfalls per unit of factor exposure. Using data for 5,323 U.S. and 2,364 international live and dead long-only equity mutual funds during January 1990 through December 2016, they find that:
- Market, value and momentum factors are far less rewarding in mutual funds than in idealized research. For U.S. mutual funds:
- Managers capture only half the ideal annual equity market premium (4.1% out of 8.2%). The shortfall widens in the aftermath of the dot-com bubble, shrinks during in the months before the global financial crisis and then widens again substantially in recent years.
- Managers capture all the annual ideal size factor and more (3.3% out of 2.6%). Size investing is fairly easy to implement with low turnover. The extra return may derive from stock picking skill.
- Managers capture about 60% of the ideal annual value factor (2.2% out of 3.6%), with the shortfall persistent over the sample period.
- Managers capture almost none of the ideal annual momentum factor (0.4% out of 5.7%). Most of the shortfall occurs by 2003.
- Across a broader set of eight factors, U.S. mutual fund managers capture an annual premium above 1% only for market, size, value, and illiquidity, all of which have low turnover.
- Fund expenses do not drive factor return shortfalls for U.S. mutual funds.
- Findings for international mutual funds are similar to those for U.S. funds:
- Managers capture less than half the ideal annual equity market premium (1.6% out of 6.3%).
- Managers capture all the ideal annual ideal size factor and more (2.3% out of 1.6%). Again, the extra return may derive from stock picking skill.
- Managers capture less than half the ideal annual value factor (2.1% out of 4.9%).
- Managers capture none of the ideal annual momentum factor (-0.6% out of 6.6%).
- Trading costs associated with portfolio rebalancing/reformation likely play a major, even dominant, role in failure to capture ideal factor returns.
In summary, evidence indicates that long-only equity mutual funds fully capture size factor returns, but they experience considerable shortfalls in capturing ideal market, value and (especially) momentum factor returns.
Cautions regarding findings include:
- More agile funds may be more efficient in capturing factor returns than indicated above.
- The methodology assumes that fund factor exposures are constant, but they may be significantly time-varying factor.
- The methodology does not account for the fact that fund managers may change styles.
