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When Less is More
(What is the Value of a Mutual Fund Manager's Tenure?)
by Craig L. Israelsen
hat's the value of a mutual fund manager's tenure? Do they improve with experience or are they (in this age of "un-managed" index funds) merely an expensive adornment? In short, does a fund manager with more time at the helm "manage" a portfolio any differently than a manager new to a fund?
To explore this question, 208 domestic equity mutual funds with at least 75% of their portfolios committed to stock and which have been in existence since at least January, 1990 were analyzed. The funds in the sample were large cap funds and had the S&P 500 as their best-fit index. The six S&P 500 index funds which met the same basic criteria were culled out of the sample and analyzed separately. The data source was Morningstar's Principia Pro Plus using data as of March 31, 2000. The 208 funds were ranked from high to low based upon length of managerial tenure and then grouped into quartiles of 52 funds each. Quartile averages for a number of fund characteristics were then computed. The first quartile represents the funds whose managers have the most tenure, while the 4th quartile represents those funds having managers with the least amount of tenure.
As seen in Figure 1, the average managerial tenure in the 1st quartile was just over 14 years and just under two years for funds in the 4th quartile. The differential in managerial tenure between the highest and lowest quartile of this sample of funds averaged 12.4 years. At first blush, one might assume that funds which have managers with more tenure are funds which have been around longer. Not so. As seen in Figure 2, the differential in managerial tenure is not due to "age" of fund. The average fund inception date for the 1st quartile was 1976 and for the 4th quartile it was 1974.
Figure 1. Manager Tenure by Quartile
|
Quartile
per quartile)
|
Manager
Tenure
(Years)
|
10
Year
Annualized
Gross
Return
|
10
Year
Average
Turnover
Ratio %
1990-99
|
10
Year
Annualized
Tax-Adjusted
Return
|
Differential
between Gross Return and Tax-Adjusted Return
(basis
points)
|
|
1st
|
14.2
|
16.7%
|
58%
|
14.3%
|
240
|
|
2nd
|
7.1
|
16.0%
|
68%
|
13.5%
|
250
|
|
3rd
|
3.9
|
16.6%
|
69%
|
14.1%
|
250
|
|
4th
|
1.8
|
15.4%
|
79%
|
12.5%
|
290
|
|
Difference
Between 1st and 4th Quartiles
|
12.4
|
130
basis points
|
36%
higher
|
180
basis points
|
50
basis points
|
|
Index
Funds
(n
= 6)
|
7.0
|
18.3%
|
6%
|
17.1%
|
120
|
Funds with the most managerial tenure (1st quartile) had the highest average annual return over the ten year period ending March 31, 2000, suggesting that managerial tenure does add value. As shown in Figure 1, the average 10 year return for the 1st quartile funds was 130 basis points higher than funds in the 4th quartile. In addition to having the highest return, funds with the most managerial tenure also had the lowest portfolio turnover ratio (see Figures 1 and 3). Funds in the fourth quartile had turnover ratios that averaged 36% higher than funds in the first quartile. The turnover ratio data in Figure 1 are 10 year averages, and not simply the figure for the most recent 12 months. The same is true of the expense ratio averages reported in Figure 2.
The difference in performance between the 1st and 4th quartiles is even more pronounced when examining after-tax returns (Figure 4). It is here that the benefit of lower turnover ratios is evident. Funds with the most managerial tenure had, on average, annual turnover ratios of about 58%, compared to 68%, 69%, and 79% for the 2nd, 3rd, and 4th quartiles. Funds in the 1st quartile increased their margin of performance over the 4th quartile funds to 180 basis points when comparing after-tax average annual return. It appears that low turnover ratio and greater managerial tenure are linked. Moreover, low turnover and/or greater managerial tenure is related to higher after-tax returns. It's possible that managers with more experience have become more tax conscious and employ management strategies intended to increase tax efficiency. Reducing portfolio turnover is one such strategy.
There are two perspectives regarding the linkage between managerial tenure and fund performance. Stability at the helm produces better performance -- or -- mutual fund managers which produce good results keep their jobs longer. It's somewhat of a chicken and egg question. Regardless, it is clear that funds which are guided by managers with more tenure have some beneficial characteristics compared to funds guided by managers with very little tenure.
For example, as seen in Figure 2, funds in the 1st quartile had higher Sharpe ratios and alpha coefficients - both of which are advantageous. The Sharpe ratio is a measure of risk-adjusted return where the larger the ratio the better. Alpha is a modern portfolio theory concept. It is the lesser known partner to beta. Alpha, as suggested by Morningstar, "can be used to directly measure the value added or subtracted by a fund's manager." The higher the alpha the better. Funds in the 1st quartile had an average alpha coefficient of -2.5, which is higher than the average of -4.0 for the 4th quartile funds. Interestingly alpha is correlated to managerial tenure. Funds with less managerial tenure have lower alpha scores, suggesting that, on average, managers with less tenure add less value to a fund's performance.
Figure 2. The Supporting Data
|
Quartile
|
Manager
Tenure
(Years)
|
10
Year Average
Expense
Ratio %
1990-99
|
Fund
Inception Year
|
Sharpe
Ratio
(3 Yr)
|
(3 Yr)
|
Median
Market Cap
($ bil)
|
Net Assets
($
mil)
|
|
1st
|
14.2
|
1.15%
|
1976
|
.87
|
-2.5
|
54.9
|
4,562
|
|
2nd
|
7.1
|
1.07%
|
1971
|
.88
|
-2.8
|
67.2
|
4,225
|
|
3rd
|
3.9
|
1.03%
|
1973
|
.84
|
-3.5
|
59.2
|
4,772
|
|
4th
|
1.8
|
1.12%
|
1974
|
.78
|
-4.0
|
59.8
|
1,724
|
|
Index
Funds
(n=6)
|
7.0
|
0.37%
|
1984
|
1.13
|
-.3
|
87.8
|
20,424
|
Funds in the 1st quartile tend to have comparable expense ratios to funds in the other three quartiles suggesting that expense ratio and managerial tenure are unrelated. Funds with the least amount of managerial tenure had significantly lower net assets than the funds in the first three quartiles. This finding is undoubtably a function of poor historical performance, rather than a direct result of less managerial tenure. The linkage between managerial tenure, fund performance, portfolio turnover, and net assets might be described as follows:
A manager whose performance begins to lag its benchmark index or peer group average may be let go, which re-starts the managerial tenure clock. The incoming manager may shuffle the portfolio to his or her liking, thus creating the correlation between less managerial tenure and higher portfolio turnover. Funds which are undergoing changes in the manager and/or are experiencing periods of relatively poor performance begin to lose assets as Investments seek higher ground.
Managerial tenure may, in large part, be a function of momentum. Funds which are doing well attract assets. Increased assets can bring financial rewards to the manager. Managers which are rewarded will likely stick around longer. Managers which stick around longer create a paradigm which fosters portfolio continuity and stability as evidenced by funds in the 1st quartile having the lowest turnover ratio, the highest Sharpe ratio and alpha coefficient, and most importantly, the highest return.
Now, the interesting part. Passively managed index funds had, as a group, the highest average annual return over the ten year period compared to the quartile averages for managed funds. This group also had a much lower turnover ratio, which had the effect of narrowing the gap between gross return and after-tax return to 120 basis points (Figure 1) as compared to between 240 and 290 basis points for actively managed funds. As would be expected, index funds had much lower expense ratios. The average for the 6 index funds was .37% compared to an average of 1.09% for managed funds. The net asset average for the index funds is skewed upwards due to the fact that among the group of six funds is Vanguard 500 Index with its $98 billion in assets. The six index funds also had a higher average Sharpe ratio and alpha score than the managed funds. This latter finding is somewhat ironic inasmuch as the alpha coefficient is used as a measure of a manager's contribution to a fund's return. Index funds, by their very nature, are not highly susceptible to managerial impact. So, for index funds to have higher alpha scores is puzzling - unless viewed from a different perspective. Perhaps a manager adds value by doing less, rather than more. Indeed, funds in the 1st quartile were more like index funds in terms of portfolio turnover ratio than were the funds of the 4th quartile.
Passively managed index funds have, on average, generated better returns than actively managed funds over the past decade as measured by gross return, tax-adjusted return, and risk-adjusted return (i.e. higher Sharpe ratio). The "value" of the management of an index fund may in large part be a function of low turnover. In other words, less management (read that as lower turnover) has, on average, produced better results -- both among actively and passively managed funds. The allure of managerial tenure may be that experienced managers have more commitment to a buy-and-hold philosophy, recognizing that less (turnover) is more (profitable).
Craig L. Israelsen, Ph.D., is an associate professor in the department of consumer and family economics at the University of Missouri-Columbia. This article was originally published in Financial Planning Magazine in September 2000.
Figure 3. Managerial Tenure and Turnover Ratio
Figure 4. Managerial Tenure and After-Tax Returns (as of 3/31/00)
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