Life-cycle funds: Much Ado about Nothing?

The core idea of life-cycle funds or target-date funds is to decrease the fund's equity exposure and conversely increase its bond exposure towards the fund's target date. Such funds have been gaining significant market share and were recently set as default choice of asset allocation in numerous defined contribution schemes or related old-age provision products in several countries. Hence, an assessment of life-cycle funds’ risk-return profiles – that is, the probability distribution of returns – is essential for sustainable financial planning of a large group of investors. This paper studies the risk-return profile of life-cycle funds in particular compared to simple balanced or lifestyle funds that apply a constant equity portion throughout the fund's term instead. In a Black–Scholes model, we derive balanced funds that reproduce the risk-return profile of an arbitrary life-cycle fund for single and regular contributions. We then analyze the accuracy of our results under more complex asset models with stochastic interest rates, stochastic equity volatility and jumps. We further show that frequently used ‘rule of thumb approximations’ that only take into account the life-cycle fund's average equity portion are not suitable to approximate a life-cycle fund's risk-return profile. Our results on the one hand facilitate sustainable financial planning and on the other hand challenge the very existence of life-cycle funds since appropriately calibrated balanced funds can offer a similar (often dominating) risk-return profile.     

Active management, fund size, and bond mutual fund returns

Conventional wisdom holds that bonds are relatively homogenous investments compared to equities. Consequently, factors that explain variation in returns among bond mutual funds may differ in magnitude from those for equity mutual funds. In this study, a time-series cross-sectional analysis is employed to investigate the relationship between a bond fund's risk-adjusted return and specific fund attributes. Results indicate that a bond fund's past performance does not predict future performance and that bond fund managers are generally ineffective at increasing risk-adjusted returns. However, unlike equity mutual funds, bond mutual funds do appear to enjoy economies of scale.     

Performance evaluation and self-designated benchmark indexes in the mutual fund industry

Almost one-third of actively managed, diversified U.S. equity mutual funds specify a size and value/growth benchmark index in the fund prospectus that does not match the fund's actual style. Nevertheless, these “mismatched” benchmarks matter to fund investors. Performance relative to the specified benchmark is a significant determinant of a fund's subsequent cash inflows, even controlling for performance measures that better capture the fund's style. These incremental flows appear unlikely to be rational responses to abnormal returns. The evidence is consistent with the notion that mismatched self-designated benchmarks result from strategic fund behavior driven by the incentive to improve flows.     

Do Funds Make More When They Trade More?

We model fund turnover in the presence of time‐varying profit opportunities. Our model predicts a positive relation between an active fund's turnover and its subsequent benchmark‐adjusted return. We find such a relation for equity mutual funds. This time‐series relation between turnover and performance is stronger than the cross‐sectional relation, as the model predicts. Also as predicted, the turnover‐performance relation is stronger for funds trading less‐liquid stocks and funds likely to possess greater skill. Turnover is correlated across funds. The common component of turnover is positively correlated with proxies for stock mispricing. Turnover of similar funds helps predict a fund's performance.     

How Does Size Affect Mutual Fund Behavior?

If actively managed mutual funds suffer from diminishing returns to scale, funds should alter investment behavior as assets under management increase. Although asset growth has little effect on the behavior of the typical fund, we find that large funds and small‐cap funds diversify their portfolios in response to growth. Greater diversification, especially for small‐cap funds, is associated with better performance. Fund family growth is related to the introduction of new funds that hold different stocks from their existing siblings. Funds with many siblings diversify less rapidly as they grow, suggesting that the fund family may influence a fund's portfolio strategy.     

Failure Risk and the Cross‐Section of Hedge Fund Returns

Modeling a hedge fund's probability of failure with a dynamic logit regression, I find that the probability of a fund's failure has a significantly negative effect on the fund's future returns. A quintile portfolio with the highest failure probability underperforms a quintile portfolio with the lowest failure probability by 5% to 6% per year from 1997 to 2012. The results are robust to the definition of hedge fund failure and controlling for a large set of risk factors and fund characteristics. Moreover, the negative effect of failure probability on future fund returns is stronger for funds with weak share restrictions.     

AN EMPIRICAL ANALYSIS OF MUTUAL FUND EXPENSES

Mutual fund investors are subjected to many fees and expenses related to both the management of the fund assets and the sale and distribution of the fund's shares. In recent years these expenses have increased as a percentage of assets. The preoccupation of mutual fund investors with using performance evaluation as a selection criterion is misguided because of the volatility of investment returns. Whether the fund's performance is due to superior management or just good luck is difficult to determine. On the other hand, mutual fund expenses are stable. As such, the mutual fund investor should pursue a policy of choosing funds with low expenses. In this paper we conduct an empirical analysis of these expenses. The results of our analysis of equity funds suggest that expense-conscious investors should look at the fund size, age, turnover ratio, cash ratio, and existence of a 12b-1 fee as key determinants of expenses. Our analysis of bond funds suggests that the key factors are the fund's sales charge, weighted average maturity, size, and existence of a 12b-1 fee.     

Mutual fund corporate culture and performance

In this paper we test if a mutual fund's own corporate culture predicts fund performance. To do this we use Morningstar's corporate culture ratings for mutual funds and then examine the ability of these corporate culture ratings to predict risk-adjusted performance of domestic equity funds over the period 2005–2010. Using methods that are robust to survivorship bias, we find there is little significant evidence that corporate culture predicts better fund performance. Indeed, we find that no individual component of the Morningstar stewardship rating including board quality, fees, manager incentives and regulatory issues is able to consistently predict fund performance.     

The investment behavior of buyout funds: Theory and evidence

We analyze the determinants of buyout funds’ investment decisions. We argue that when there is imperfect competition for private equity funds, the timing of funds’ investment decisions, their risk-taking behavior, and their subsequent returns depend on changes in the demand for private equity, conditions in the credit market, and fund managers’ ability to influence perceptions of their talent. We investigate these hypotheses using a proprietary dataset of 207 U.S. buyout funds that invested in 1,957 buyout targets over a 30-year period. Our dataset contains precisely dated cash inflows and outflows in every portfolio company, links every buyout target to an identifiable buyout fund, and is free from reporting and survivor biases. Thus, we are able to characterize every buyout fund's precise investment choices. Our findings are as follows. First, established funds accelerate their investment flows and earn higher returns when investment opportunities improve, competition for deal flow eases, and credit market conditions loosen. Second, the investment behavior of first-time funds is less sensitive to market conditions. Third, younger funds invest in riskier buyouts, in an effort to establish a track record. Finally, following periods of good performance, funds become more conservative, and this effect is stronger for first-time funds.     

Outsourcing Mutual Fund Management: Firm Boundaries,Incentives, and Performance

We investigate the effects of managerial outsourcing on the performance and incentives of mutual funds. Fund families outsource the management of a large fraction of their funds to advisory firms. These funds underperform those run internally by about 52 basis points per year. After instrumenting for a fund's outsourcing status, the estimated underperformance is three times larger. We hypothesize that contractual externalities due to firm boundaries make it difficult to extract performance from an outsourced relationship. Consistent with this view, outsourced funds face higher powered incentives; they are more likely to be closed after poor performance and excessive risk‐taking.     

Meeting new peers: The effects of Morningstar category reassignment on fund flows and star ratings

We investigate how the reassignment of a fund's Morningstar category affects fund flow and Morningstar star rating. We find that funds assigned to a different category gain positive abnormal flows and this effect is significant mainly for high-rated funds. Category reassignment does not improve a fund's star rating on average, and flows are less responsive to a star-rating change if the rating change is likely to be driven by category reassignment. The positive abnormal flows captured by high-rated funds after category reassignment are consistent with a visibility story: some investors filter funds by Morningstar category and star rating, and category reassignment makes a fund more visible to a new group of investors if the fund is highly rated. In contrast, a low-rated fund is likely to be selected only by investors who do not refer to the fund's Morningstar information and, hence, gains little visibility from category reassignment. We also find evidence that more sophisticated investors are more likely to consider not only fund rating but also fund category when evaluating fund performance.     

The Role of the Auditor in Modern Society: An Exploratory Essay

This paper examines competing proprietary and political cost arguments for incentives facing managers of different types of Australian and UK pension fund, to voluntarily disclose pension liability information in annual reports sent to their participants. For Australian defined benefit pension funds, the disclosure reveals the fund's actuarial surplus or deficit, which conveys information to participants about the pension fund's ability to generate future cash flows. Tests are conducted on the voluntary reporting practices of a sample of 119 Australian and 100 UK pension funds, using variables which prior research suggests affects their financial valuation and performance. The empirical results support predictions that managerial discretionary disclosure carries proprietary cost implications for Australian defined benefit pension funds, as proxied by their investment risk and funding ratio, and political cost implications for Australian defined contribution and UK defined benefit pension funds, as proxied by their size.     

Who Charges More: Hedge Funds or Mutual Funds?*

Explicit mutual fund fees are typically less than 1% of the assets under management. By comparison, the typical hedge fund charges a base fee of 2% plus a performance fee equal to 20% of net profits. Thus, hedge funds appear to charge far more for even comparable performance—unless one takes account of the following:

• ? For most mutual funds, a very high percentage of performance is driven by its passive exposure to the market, even though the fee is applied to the total fund.
• ? Many hedge funds are designed to provide returns that are completely independent of market performance.

Using these two assumptions, the author provides a simple example that shows that a representative mutual fund's performance can be replicated by combining an index fund, which represents the mutual fund's passive component, with a hedge fund, representing the mutual fund's active component. When analyzed in this way, the fee of the combined fund turns out to be remarkably close to the actual fee of the mutual fund. This in turn suggests that the implicit fee for the mutual fund's small active component is comparable to the fees of the hedge fund.     

Closed-End Fund Discounts with Informed Ownership Differential

We develop a multiasset trading model to examine the closed-end fund discount. The model shows that the discount can arise if the quality of private information in the underlying assets is sufficiently better than in the fund. The model also indicates that a discount (premium) can arise if the excessive volatility of the fund dominates (is dominated by) the fund's diversification benefit. Moreover, the model predicts a negative relation between the discount and the institutional ownership differential, as arbitrageurs prefer funds with large discounts. Using a sample of U.S. equity closed-end funds, we test these predictions and find supporting evidence. Journal of Economic Literature Classification Numbers: D82, G10, G12, G14.     

Not only skill but also scale: Evidence from the hedge funds industry

This paper empirically tests a two-levels model of decreasing returns to scale using a sample of hedge funds. The two-levels model assumes that a fund's gross alpha is a decreasing function of both the fund scale and the style scale measured by the aggregate size of peers in the hedge fund style. We find that a fund-level model underestimates the impact of diseconomies of scale on the gross alpha by 55 basis points. The results indicate that managers should consider the constraints imposed by the style scale when optimizing their portfolio sizes. We also provide evidence that hedge funds did not invest at their optimal amount and confirm that skill and the ability to resist decreasing returns to scale are two important components of selecting hedge fund performers.     

Leveraged Buyouts in the U.K. and Continental Europe: Retrospect and Prospect

The markets for management buyouts in the U.K. and continental Europe have experienced dramatic growth in the past ten years. In the U.K., buyouts accounted for half of the total M&A activity (measured by value) in 2005. And as in the U.S. during the‘80s, the greatest number of U.K. buyouts in recent years have been management‐ and investor‐led acquisitions of divisions of large corporations. In continental Europe, by contrast, the largest fraction of deals has involved the purchase of family‐owned private businesses. But in recent years, increased pressure for shareholder value in countries like France, Netherlands, and even Germany has led to a growing number of buyouts of divisions of listed companies. Like the U.K., continental Europe has also seen a small but growing number of purchases of entire public companies (known as private‐to‐public transactions, or PTPs), including the largest ever buyout in Europe, the €13 billion purchase this year of the Danish corporation TDC. In view of the record levels of capital raised by European private equity funds in recent years‐which, until 2005, exceeded the amounts invested in any given year‐we can expect more growth in private equity investment in the near future. In continental Europe, the prospects for buyouts remain especially strong, given both the pressure from investors to restructure larger corporations and the possibilities for adding value in family‐owned firms. But, as the authors note, today's private equity firms face a number of challenges in earning adequate returns for their investors. One is increased competition. In addition to the increased activity of U.S. private equity firms, local private equity investors are also facing competition from hedge funds and new entrants such as government‐sponsored operators, family offices, and wealthy entrepreneurs. Another major challenge is finding value‐preserving exit vehicles. Although an IPO is an option for the largest buyouts with growth prospects, most buyout investments are harvested either through sales to other companies or, increasingly, other private equity firms. The latter transactions, known as “secondary” buyouts, now account for a significant share of new funds invested by private equity firms across Europe.     

Why do fund managers increase risk?

This paper examines the relationship between the increase in fund risk and subsequent cash flows. We attempt to test the hypothesis that an increase in fund risk actually increases the net flows of equity funds, which is a basic assumption of risk shifting. We find that a change in fund risk has a positive and convex relationship with the fund's net flows. The effect of risk changes on net flows is a natural consequence of its effects on inflows and outflows. This paper's empirical results are robust to return frequency, fund age, and fund size. Our findings create incentives for managers to shift risk as documented in the mutual fund literature.     

Risk and return in convertible arbitrage: Evidence from the convertible bond market

In this paper, we identify and document the empirical characteristics of the key drivers of convertible arbitrage as a strategy and how they impact the performance of convertible arbitrage hedge funds. We show that the returns of a buy-and-hedge strategy involving taking a long position in convertible bonds (“CBs”) while hedging the equity risk alone explains a substantial amount of these funds' return dynamics. In addition, we highlight the importance of non-price variables such as extreme market-wide events and the supply of CBs on performance. Out-of-sample tests provide corroborative evidence on our model's predictions. At a more micro level, larger funds appear to be less dependent on directional exposure to CBs and more active in shorting stocks to hedge their exposure than smaller funds. They are also more vulnerable to supply shocks in the CB market. These findings are consistent with economies of scale that large funds enjoy in accessing the stock loan market. However, the friction involved in adjusting the stock of risk capital managed by a large fund can negatively impact performance when the supply of CBs declines. Taken together, our findings are consistent with convertible arbitrageurs collectively being rewarded for playing an intermediation role of funding CB issuers whilst distributing part of the equity risk of CBs to the equity market.     

AGENCY CONFLICTS IN DELEGATED PORTFOLIO MANAGEMENT: EVIDENCE FROM NAMESAKE MUTUAL FUNDS

Namesake funds provide a unique sample for studying the two agency conflicts that exist within a mutual fund. The first is between the fund management company and fund shareholders, and the second is between the fund management company and the fund manager. A typical namesake fund manager sits on his or her fund's board, frequently as the chairman, is the majority owner of the fund management company, and has significant investments in the fund he or she manages. Our results indicate that namesake funds charge higher fees, suggesting that the boards of namesake funds are less effective. We find that namesake funds are more tax efficient, consistent with the idea that managerial ownership helps align the interests of managers with those of shareholders. Because of fewer career concerns, namesake fund managers herd less while assuming greater unsystematic risk. We find weak evidence that namesake fund managers outperform their benchmarks and peers. Finally, we observe that namesake funds attract higher levels of investor cash flow.     

Portfolio concentration and fund manager performance

This research examines the relationships among portfolio concentration, fund manager skills, and fund performance in Taiwan's equity mutual fund industry, yielding several empirical findings as follows. First, after controlling for other factors, concentrated equity funds tend to have smaller net asset values, larger fund flows, higher turnover rates, and a younger age and prevail in smaller fund families. Second, concentrated fund managers buy and sell stocks more smartly based on economic trends or market factors than do diversified fund managers, i.e., they have better market‐timing abilities. Third, only partial evidence supports the premise that concentrated equity funds have better next‐quarter risk‐adjusted performances than do diversified ones, as these fund managers' skills positively correlate to risk‐adjusted fund performance. Fourth, fund managers who have better stock‐picking abilities and intensively invest in certain industries generally exhibit better Carhart's alpha in the next quarter than do other fund managers. Fifth, fund managers' stock‐picking abilities more closely relate to long‐term performance than do their market‐timing abilities. Lastly, positive performance persistence is much stronger than negative performance persistence, but concentrated funds do not have stronger performance persistence than do diversified funds.