Ep72 Alternatives vs. Mutual Funds: Where Should You Put Your Money

Key Concepts

• Delegated Money Management: The practice of entrusting investment decisions to professional managers.
• Mutual Funds: Publicly accessible investment vehicles investing primarily in publicly traded stocks, characterized by fixed percentage fees.
• Alternatives: Private investment vehicles (private equity, hedge funds, venture capital) with restricted access, typically employing a “two and twenty” (2% management fee + 20% performance fee) structure.
• Flow-Performance Relationship: The tendency for capital to flow towards funds with superior performance and away from underperforming funds.
• Alpha: A measure of investment performance relative to a benchmark, representing excess return. (Gross Alpha vs. Net Alpha)
• Value Added: Gross alpha multiplied by fund size, considered a more accurate measure of manager skill.
• Incentive Compatibility: Ensuring investors have the right incentives to truthfully reveal information and act in their best interests.
• Rent Extraction: The process of capturing all potential profits from an investment.
• Illiquidity: The difficulty of quickly converting an asset into cash without significant loss of value.

Mutual Funds: A Well-Understood Space

The discussion begins by establishing a framework for understanding delegated money management, differentiating between mutual funds and alternatives. Mutual funds are defined as public delegated management, accessible to all investors and primarily focused on publicly traded stocks. Three key empirical facts characterize this space:

1. Fixed Percentage Fee: Managers are compensated via a fixed percentage of assets under management (e.g., 1% of $1 billion).
2. Flow-Performance Relationship: Funds experience inflows when outperforming benchmarks and outflows when underperforming. This isn’t irrational; superior performance signals greater manager skill, justifying increased capital allocation.
3. Zero Net Alpha: Despite potential gross alpha (performance before fees), competition drives net alpha (performance after fees) to zero. Investors rationally compete for skilled managers, eliminating excess returns.

This understanding stems from research by Berk and Green, who demonstrated that the flow-performance relationship isn’t an anomaly but a rational response to manager skill. The correct measure of manager ability isn’t alpha itself, but value added – gross alpha multiplied by fund size. This metric predicts future performance, confirming the existence of skill within the mutual fund space. The existing contract structure (fixed percentage fee) is optimal because it aligns with the flow-performance dynamic.

Alternatives: A Puzzle and a New Theory

The conversation shifts to alternatives – private delegated capital management – encompassing hedge funds, private equity, and venture capital. These investments are privately intermediated, inaccessible to the general public, and typically invest in private assets (though hedge funds may also trade public markets). Several key differences emerge:

1. Positive Alpha: Unlike mutual funds, alternatives often exhibit positive average alpha, a significant puzzle.
2. Fund Size Caps: Managers routinely limit the size of their funds, foregoing potential profits, a behavior not observed in mutual funds.
3. Two and Twenty Contract: Alternatives employ a “two and twenty” fee structure (2% management fee + 20% of profits), contrasting with the fixed percentage fee in mutual funds.

These differences have long puzzled researchers. The data in alternatives is less reliable than in mutual funds due to reporting inconsistencies. However, the superior performance of university endowments, heavily invested in alternatives, suggests a genuine positive alpha.

Berk and DeMarzo propose a new theory centered on the illiquidity of alternative investments. Unlike publicly traded stocks, alternative assets are difficult to quickly sell without significant loss. This illiquidity necessitates thorough manager investigation, creating a costly due diligence process. This leads to:

• Information Asymmetry: Investors need to assess manager skill before committing capital for extended periods.
• Free Rider Problem: Investors can benefit from the due diligence of others without incurring the cost, creating a disincentive to investigate independently.
• Fee Breaks for Investigators: To incentivize investigation, informed investors receive lower fees.
• Optimal Contract Structure: The “two and twenty” contract is optimal because it extracts all rents and aligns the incentives of informed investors. The performance fee ensures managers are motivated to generate returns, while the cap on fund size prevents them from exploiting uninformed investors by lowering fees to attract more capital.

The Role of Fund Size Caps and Incentive Compatibility

The fund size cap is crucial for incentive compatibility. Without a cap, managers could lower fees to attract more capital, benefiting themselves at the expense of informed investors. The cap, negotiated ex ante (before investment), prevents this behavior. The theory explains why the cap exists and why it’s determined by the amount of investment from informed investors. The two and twenty contract is also optimal because it avoids the risk of a manager becoming insolvent and being unable to fulfill performance-based obligations.

Conclusion

The discussion culminates in a unified theory explaining the differences between mutual funds and alternatives. The key driver is the illiquidity of alternative investments, necessitating costly manager investigation and leading to a different contract structure and investment dynamic. The positive alpha observed in alternatives isn’t “free money” but a reward for diligent due diligence. This has significant implications for policy debates regarding access to alternatives for broader investors, suggesting that the benefits are primarily realized by those willing to invest in the necessary research and expertise. The research, detailed in the paper “A Unified Theory of Delegated Capital Management,” provides a robust framework for understanding the complexities of delegated investment management.