Antti Petajisto

Active Share and Mutual Fund Performance

I sort domestic all-equity mutual funds into different categories of active management using Active Share and tracking error. I find that over my sample period until the end of 2009, the most active stock pickers have outperformed their benchmark indices even after fees and transaction costs. In contrast, closet indexers or funds focusing on factor bets have lost to their benchmarks after fees. The same long-term performance patterns held up over the 2008-2009 financial crisis, and they also hold within market cap styles. Closet indexing increases in volatile and bear markets and has become more popular after 2007. Cross-sectional dispersion in stock returns positively predicts average benchmark-adjusted performance by stock pickers.

Why Do Demand Curves for Stocks Slope Down

Representative agent models are inconsistent with existing empirical evidence for steep demand curves for individual stocks. This paper resolves the puzzle by proposing that stock prices are instead set by two separate classes of investors. While the market portfolio is still priced by individual investors based on their collective risk aversion, those individual investors also delegate part of their wealth to active money managers, who use that capital to price stocks in the cross section. In equilibrium, the fee charged by active managers has to equal the before-fee alpha they earn. This endogenously determines the amount of active capital and the slopes of demand curves. A calibration of the model reveals that demand curves can be steep enough to match the magnitude of many empirical findings, including the price effects for stocks entering or leaving the S&P 500 index.

Global Return Premiums on Earnings Quality, Value, and Size

We investigate the return premium on stocks with high earnings quality using a broad and recent global dataset covering all developed markets from 7/1988 to 6/2012. We find that a simple strategy that is long stocks with high earnings quality and short stocks with low earnings quality produces a higher Sharpe ratio than the overall market or similar strategies betting on value or small stocks. This result holds both in the overall sample as well as in the more recent time period since 2005. Because the global earnings quality portfolio has a negative correlation with a value portfolio, an investor wishing to invest in both exposures can achieve significant diversification benefits.

What is the True Cost of Active Management? A Comparison of Hedge Funds and Mutual Funds

ANTTI PETAJISTO is a portfolio manager at BlackRock. antti.petajisto@sloan.mit.edu Are hedge funds more expensive than mutual funds? Initially the answer may seem obvious: hedge funds typically charge a management fee of about 2%, slightly higher than the usual fee of about 1% charged by actively managed mutual funds, plus an incentive fee that typically amounts to 20% of any positive profits. Hence, hedge funds clearly charge higher fees per dollar invested. Do they also deliver more in return for those fees? Naturally a hedge fund manager would claim they deliver greater alpha due to their superior skills. But what if the hedge fund and the mutual fund manager are about equally skilled? How do the mutual fund and hedge fund structures differ as vehicles to deliver alpha to investors, and which allows the investor to benefit more from a given manager’s skills? This question has become more important recently as new legislation and regulation in the United States and the European Union has been increasing the costs of opening new hedge funds, thus making the mutual fund structure relatively more attractive to active managers. To the extent that this regulatory change pushes active managers to choose to run mutual funds instead of hedge funds, does this mean investors are getting a better deal and paying lower fees for active management? We point out that the answer is far from obvious. In this article we investigate whether investors are better off investing in hedge funds or mutual funds, and how this trade-off varies for a range of plausible parameter values. We also explain the costs and benefits of each fund structure from the investor’s point of view. Our approach is conceptual: We want to understand the mechanism of the trade-off, so rather than estimating various relevant quantities from the hedge fund and mutual fund data ourselves, we use other researchers’ estimates to evaluate the trade-off for investors. Further, by using the trade-off, our model explains several documented empirical f indings on the career development of successful fund managers and on hedge funds’ risk-taking (see e.g., Li et al. [2011] and Nohel et al. [2010]). The simplest trade-off comes from the effect of leverage: A hedge fund can use leverage to scale up the manager’s bets for each dollar of the investor’s capital, generating a greater alpha, albeit with greater idiosyncratic volatility, than the active mutual fund, and hence offsetting the higher management fee. In this sense, the hedge fund can indeed provide more active management for each dollar invested. Another potential cost for mutual-fund investors arises from the market exposure embedded in their actively managed fund: If investors are not able (perhaps due to institutional constraints) to hedge out the market