Why complex mutual fund strategies don’t pay off

New research has found that complex investment strategies in mutual funds lead to underperformance and higher fees

Why complex mutual fund strategies don’t pay off
A new research study has found that the use of complex investment strategies in mutual funds leads to underperformance, greater risk and higher fees.

Conducted by three professors from the Smith School of Business at Queen’s University, the research found that mutual funds using leverage, short sales and options (called complex instruments) generate statistically significant lower excess returns and four-factor alphas relative to funds that choose more simplistic methods.

“In other walks of life, we usually associate cutting edge technology and complexity with the best possible outcome,” says one of the report’s authors, Professor Paul Calluzzo. “I think the study highlights that, in the money management space, more complexity isn’t necessarily going to be associated with the best customer outcomes.”

The study, which tracked the performance of 4,793 mutual funds that invest in complex instruments from 1990-2015, discovered that complex instruments tend to underperform for two fundamental reasons: investment costs and investment decisions. Many complex instruments are expensive to trade, so if trades are not generating positive returns that has a drag on the overall result. The making of bad bets is another factor impacting the performance of mutual funds that use complex strategies.

“At the business school we teach that investors should aim to have portfolios with all systematic risk and no idiosyncratic risk; you want to diversify all of that away,” Professor Calluzzo says. “Our research found that, when mutual funds use these complex instruments, the opposite happens - they have lower systematic risk and higher idiosyncratic risk.”

But it wasn’t all bad news for funds that use complex instruments. The study found that where fund managers use complex instruments in the presence of high levels of institutional ownership, these funds are not associated with negative shareholder outcomes.

“That finding shows that complex instruments can be used for good, but can also provide temptation for managers to use them in less good ways,” says Professor Calluzzo. “The use of complexity is not necessarily bad, but investors should be cautious and look for fund companies that have good management. We measure that by how much institutional money is in that fund family. In fund families where there are high levels of institutional ownership, we don’t see any of the negative effects. That’s a way to tease out the good side of complexity.”

“If a fund family has a clear mandate as to why they want to use those instruments, that can create some discipline, which allows them to use those complex strategies for the good of the shareholder.”

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