Hard Evidence of a Mutual Fund Brain Drain

Anecdotal evidence for an exodus of the best mutual fund managers to the high return world of hedge funds has been around for over a decade.

But how to go about using the numbers to prove it? Have enough hot shots of the mutual fund world crossed the hedge such that mutfund returns are visibly lower? And are mutual funds losing out on the best university graduates too?

To get around the fact that it's next to impossible to figure out why a mutual fund manager might have left his/her job, Leonard Kostovetsky, a graduate fellow at Princeton, looks only at the people most likely to leave for a hedge fund (and not something else): the top performing managers who are under 25.

Hefinds the chance that such a manager would leave the mutual fund industry increased from 4.6 percent between 1993-1998 to 10.8 percent between 1999-2005. (Kostovetsky uses 1999 as the first year of the hedge fund effect because that's about the time anecdotal evidence of an exodus hit its peak in the popular press.)

The percentage of mutfund managers with degrees from top biz schools also fell from 37.2 percent to 35.7 percent. Here, Kostovetsky reduces the pool of managers he looks at to just the Northeast region on the theory that since 80 percent of the largest hedge funds are in the Northeast, then a brain drain is more likely to show up there.

Using this assumption, he finds that the percentage of mutfund managers with degrees from top biz schools fell 17.1 percent (from 55.5 percent to 38.5 percent).

So, do these developments hurt returns? Apparently they do.

Between 1999 and 2005, the relative return of younger Northeast managers fell by an annual average of 0.15%.

And the prognosis doesn't look good for mutual funds (or investors without access to hedge funds), Kostovetsky says:

As older managers retire and are replaced by the current crop of young managers, and as more hedge funds are opened outside the Northeast, the decrease in returns that is now isolated to mutual funds managed by younger managers in the Northeast will increasingly affect all funds.