Fund families seem to be aware of the relationship among skill, efficiency, and performance. The authors find that manager skill is rewarded more in less efficient markets and that, as a result, fund families allocate more skilled managers to those market segments.
The authors’ objective is to show that fund families are aware that manager skill is rewarded more in less efficient markets than in more efficient markets. Consequently, fund families rationally allocate more skilled managers to less efficient market segments and, by doing so, increase average alpha, attract new money inflows, and increase fee income.
How Is This Research Useful to Practitioners?
According to the authors, manager skill (measured by the average SAT score of the manager’s matriculating institution) has a greater impact on performance in the less efficient high-yield (HY) segment than in the more efficient investment-grade (IG) segment. Fund families allocate managers to market segments according to manager skill and market efficiency. They pursue this strategy when hiring new fund managers and when reassigning managers to funds within the family.
Interestingly, using manager-related control variables reveals that managers with extensive investment experience tend to underperform. The impact of the manager’s educational background on the fund performance is mixed at best. The results from the fund control variables suggest that the bond funds are not subject to diseconomies of scale. There is a positive relationship between size and performance, and as expected, the authors find that the expense ratio and turnover have a negative impact on the returns.
How Did the Authors Conduct This Research?
The authors use data from the Center for Research in Security Prices (CRSP) Survivor-Bias-Free US Mutual Fund Database from 1991 to 2010. They use Lipper, Wiesenberger, and Strategic Insight to determine whether the fund is an HY or IG fund. The information on fund managers comes from the Morningstar Principia database; it provides information on the various educational degrees of the 423 managers. The average matriculant’s SAT score at the institution where the manager obtained his or her bachelor’s degree is used as a proxy for the manager’s skill.
The HY segment is much less efficient than the IG segment. In a more efficient market, index funds outnumber actively managed funds because it does not pay to actively manage a fund in an efficient market. The authors find that the proportion of index funds is 18% in the IG segment and only 2% in the HY segment.
To test their main hypothesis—that skill in less efficient markets is more valuable than in more efficient markets—the authors calculate alphas from four different models. In the next regression, these alphas are used as the dependent variables. A dummy variable (HY = 1 or IG = 0), the proxy for manager skill (SAT score), and an interactive term for the dummy variable and SAT scores are used as independent variables. Various fund- and manager-related control variables are also used as independent variables. The results show that skill pays off more in the less efficient HY segment than in the more efficient IG segment.
Next, the authors use a probit model, with the probability of a manager’s allocation to the HY segment serving as the dependent variable. The model uses different measures of manager skill and manager-related control variables as independent variables. The results show that a manager with a higher level of relative skill has a higher probability of getting assigned to an HY fund.
This study is the first of its kind, and the conclusions are very interesting. The authors have used different ways of measuring skill and performance. The results of this study are robust over time and remain stable with the use of different estimation approaches; the authors control for manager- and fund-related variables. But I do think that the SAT score of the manager’s matriculating institution is a weak proxy for manager skill.