Mutual fund managers are often rewarded for their ability to generate alpha — the ability to outperform on a risk-adjusted basis — but new research from the U.S. Federal Reserve Board argues that there’s a separate skill in operating efficiently too.
In a new staff working paper, the authors propose a new metric of fund manager performance — efficiency, which they define as the ability to capture the risk premium associated with various risk factors, such as market risk (beta), momentum, growth vs. value, and large cap vs. small cap.
“In conventional performance evaluation, full efficiency is implicitly assumed and alpha is attributed entirely to skill. However, in the presence of implementation costs, accruing risk premia is itself a form of ability, and by measuring it we obtain important new insights into manager heterogeneity and performance persistence,” the paper says.
Indeed, the paper argues that there are two types of fund manager skill — the ability to generate alpha, and the ability to capture beta and other risk premia in the face of obstacles, such as implementation costs, capacity constraints, and other impediments that fund managers may face.
Using data on all U.S. equity mutual funds from 1999 to 2023, the authors aim to demonstrate that both “skill” and “efficiency” are factors in distinguishing performance among funds, and that these differences can be significant.
“Put simply, some funds earn a higher risk premium for exposure to the same risk factor. These differences can be economically large, in addition to being statistically significant,” the paper says.
These capabilities are also negatively correlated, they found.
“Higher skilled funds tend to be less efficient, and vice versa,” it said. “This is consistent with these tasks each requiring manager attention or effort, and good performance in one task detracts from performance in the other.”
However, the authors also find evidence that efficiency is more durable than skill.
“This is consistent with efficiency being a more fundamental property of the manager (or manager’s investment process, liquidity management, execution costs, etc.) and with skill being more attributable to luck,” it said.
Finally, they say that predictions of future abnormal returns “can be significantly improved by decomposing past abnormal returns into skill and efficiency” rather than considering both factors together.