Measuring Economic Rents in the Mutual Fund Industry ∗

We introduce a new measure of active mutual fund manager skill that is based on the dollar-value a manager adds as opposed to the abnormal return he generates. We find that not only does skill exist (the average mutual fund manager adds about $2 million per year), but it is persistent, as far out as 10 years. We further document that investors recognize this skill and reward it by investing more capital with skilled managers. Not only are higher skilled managers paid more, but there is a strong positive correlation between current compensation and future performance. Finally, we find no evidence of a superstar effect — managers are compensated proportionately in the value they add. ∗We could not have conducted this research without the help of the following research assistants for which we are grateful: Ashraf El Gamal, Maxine Holland, Christine Kang, Fon Kulalert, Ian Linford, Binying Liu, Jin Ngai, Michael Nolop, William Vijverberg and Christina Zhu. We thank Rick Green, Ralph Koijen, Anamaria Pieschacon, Paul Pfleiderer and seminar participants at Robeco, Stanford, University of Chicago and the Stanford Berkeley joint seminar for helpful comments and suggestions. An important principle of economics is that agents earn economic rents if and only if they have a skill in short supply. As central as this principle is to microeconomics, surprisingly little empirical work has addressed the question of whether or not talent is actually rewarded, or, perhaps more interestingly, whether people without talent can earn rents. One notable exception is the research on mutual fund managers. There, an extensive literature in financial economics has been amassed that has focused on the question of whether stock picking or market timing talent exists. The overall conclusion of that literature is that it does not. Considering that mutual fund managers are amongst the highest paid members of society, this conclusion represents a clear violation of the economic principal relating skill to rents. It implies that it is possible to make economic rents without possessing a skill in short supply. Given the importance of the question, the objective of this paper is to re-examine whether or not mutual fund managers do earn economic rents without possessing skill. In contrast to the existing literature, we find that the average mutual fund manages does have skill, and uses his talents to add value — about $2 million a year. As to be expected, this skill is persistent. We show that it is possible, using our measure of skill, to predict long-term performance, in some cases as long as 10 years into the future. Unlike other high reward industries (like movies or sports), we find no evidence of a superstar effect as defined by Rosen (1981). On the other hand, we do find that the distribution of managerial talent is consistent with the predictions of Lucas (1978) — higher skilled managers manage larger funds and reap higher rewards. Our methodology for measuring the value managers add differs from prior work in a number of important respects. First we use all actively managed equity mutual funds thereby greatly increasing the power of our tests. Prior work has shorter time periods and focused attention exclusively on funds that hold only U.S. stocks. Second, we use a tradable benchmark to evaluate managers. Prior work has used portfolios that not only are not marketed (and so ignore transactions costs) but were also not necessarily known at the time. Our benchmark consists of all available Vanguard index funds (including funds that hold non-U.S. stocks). Finally, most prior studies use the net alpha to investors, i.e., the average abnormal return net of fees and expenses, as the measure of managerial skill. However, as Berk and Green (2004) argue, if managerial skill is in short supply, the return to investors is determined in equilibrium by competition between investors, and not by the skill of managers. One might hypothesize, based on this insight, that the gross alpha (the average abnormal return gross of fees and expenses) would be the correct measure of managerial skill, but this hypothesis is also flawed. The gross alpha is a return measure, not a value measure. That is, a manager who adds a gross alpha of 1% on a $10 billion fund adds more value than a manager who adds a gross alpha of 10% on a $1 million fund. Thus the correct measure of managerial skill is the product of the manager’s gross alpha and assets under management. This measure consists of two pieces: the amount of money the manager takes home for himself (his fee multiplied by