Democracy wins over autocracy, even in mutual funds.
A mutual fund’s decision-making structure can have a big impact on its performance and overall risk profile, according to recent research. A general rule of thumb seems to be the more decentralized, the better.
Mutual fund teams with more egalitarian decision-making structures — as opposed to hierarchical — tend to generate higher annual performance. In line with that, they also show more skill at security selection, according to a research paper titled, “The Leadership Effect: Evidence from the Fund Industry,” from Saurin Patel, an associate professor at Western University, Sergei Sarkissian, an associate professor at McGill University, and Yu Xia, an assistant professor at the University of Manitoba. The authors look at how the decision-making structures at U.S equity mutual funds affected overall performance and risk-taking measures.
Patel, Sarkissian, and Xia collected data about mutual funds from public filings with the Securities and Exchange Commission and separated them into two categories: those managed by what they call vertically-managed teams and those with a horizontally-managed structure. The researchers defined a horizontally-managed team as one without a lead manager, a structure they said signaled a more democratic approach to decisions. In contrast, a vertically-managed team reports to a single manager, indicating a more autocratic or hierarchical decision-making process.
According to the paper, these two types of leadership structures yield “significant performance differences.” Teams that report to one lead manager — vertical teams — underperform their more democratic counterparts by 50 to 75 basis points per year.
Teams with a single lead manager also hold less concentrated, and more diversified, portfolios, a less intuitive finding but one that can lead a portfolio to deliver more average or mediocre returns. Diversity reduces risk, but hundreds of stock picks can also weigh on returns. According to previous literature the authors cited, more concentrated, or best ideas, portfolios take higher risk and can potentially generate higher returns. But their efforts to manage risks by diversifying into hundreds of stocks are diluting their returns. The issue of whether portfolio managers have a better — or worse — chance of outperforming benchmarks when they run concentrated portfolios is far from settled.
The research also found that in addition to their underperformance, these funds take on slightly more market risk in their portfolios than funds with more egalitarian teams. Patel, Sarkissian, and Xia tested the level of risk in portfolios managed by the two different types of team structures. According to the paper, funds with lead managers hold “marginally” more market risk in their portfolios than teams with more decentralized structures. Market risk (or systematic risk) includes sources like recessions, political turmoil, and interest rates – risk that affects the entire market at once. Diversification doesn’t help mitigate this kind of risk.
What’s more, centralized teams tend to have less “residual risk” – or unsystematic risk — in their portfolios. Residual risk is specific to a company or holding and can be helped by diversifying. In the end, this means that vertically-managed funds typically run more diversified portfolios.
According to the paper, the fact that investment teams with more centralized power take on more market risk and have less residual risk is one indicator that they are generally less skilled at selecting securities.
“Using the fund industry as a laboratory, our evidence showing a clear performance dominance of horizontal team-management structure…” Patel, Sarkissian, and Xia wrote.