The Relation between Price and Performance in the Mutual Fund Industry

Gruber (1996) drew attention to the puzzle that investors buy actively managed equity mutual funds, even though on average such funds underperform index funds. We uncover another puzzling fact about the market for equity mutual funds: Funds with worse before-fee performance charge higher fees. This negative relation between fees and performance is robust and can be explained as the outcome of strategic fee-setting by mutual funds in the presence of investors with different degrees of sensitivity to performance. We also find some evidence that better fund governance may bring fees more in line with performance.     

Another Puzzle: The Growth in Actively Managed Mutual Funds

Mutual funds represent one of the fastest growing type of financial intermediary in the American economy. The question remains as to why mutual funds and in particular actively managed mutual funds have grown so fast, when their performance on average has been inferior to that of index funds. One possible explanation of why investors buy actively managed open end funds lies in the fact that they are bought and sold at net asset value, and thus management ability may not be priced. If management ability exists and it is not included in the price of open end funds, then performance should be predictable. If performance is predictable and at least some investors are aware of this, then cash flows into and out of funds should be predictable by the very same metrics that predict performance. Finally, if predictors exist and at least some investors act on these predictors in investing in mutual funds, the return on new cash flows should be better than the average return for all investors in these funds. This article presents empirical evidence on all of these issues and shows that investors in actively managed mutual funds may have been more rational than we have assumed.     

The index fund rationality paradox

Mutual funds that track the S&P 500 are popular because they have significantly lower costs than the average, actively managed equity fund. However, a measurable number of investors select index funds with excessive fees and uncompetitive returns. We call this observation the Index Fund Rationality Paradox because it conflicts with the belief that index fund investors are making a rational, low-cost choice in their ‘type of fund’ decision. In our analysis of this paradox, we find that both retail and institutional index investors tended to make better choices in recent years, but the cost of poor choices among both groups continues to be significant. In fact, we are able to identify an arguably naïve group of retail investors that seem to be unduly influenced by brokers and financial advisors. These investors are largely responsible for the remaining paradox.     

Cautious Risk Takers: Investor Preferences and Demand for Active Management

Despite their mediocre mean performance, actively managed mutual funds are distinct from passive funds in their return distributions. Active value funds better hedge downside risk, while active growth funds better capture upside potential. Since such performance features may appeal to investors with tail‐overweighting preferences, we show that preferences for downside protection and upside potential estimated from the empirical pricing kernel can help explain active fund flows in the value and growth categories, respectively. This effect of investor risk preferences varies significantly with funds' downside‐hedging and upside‐capturing ability, with levels of active management, and across retirement and retail funds.     

The Mismatch Between Mutual Fund Scale and Skill

I demonstrate that skill and scale are mismatched among actively managed equity mutual funds. Many mutual fund investors confuse the effects of fund exposures to common systematic factors with managerial skill when allocating capital among funds. Active mutual funds with positive factor-related past returns thus accumulate assets to the point that they significantly underperform. I also show that the negative aggregate benchmark-adjusted performance of active equity mutual funds is driven mainly by these oversized funds.     

THE PERFORMANCE OF BANK‐MANAGED MUTUAL FUNDS

The ability of banks to offer proprietary mutual funds has expanded over recent years, and the mutual fund industry has been a significant growth area for banks. I examine the growth and performance of bank proprietary bond mutual funds. The empirical results show no evidence that bank‐managed mutual funds underperform nonbank funds. I find some evidence that bank managers are more conservative than nonbank managers in terms of investment strategy and that banks appear more likely to target individual rather than institutional investors. Also, I find that abnormal fund performance does not appear to be a significant determinant of the net asset flows into and out of bank‐managed mutual funds. Rather, the results suggest bank investors rely mainly on past marketing information and the general reputation of the bank. JEL classification: G11, G21     

Diversification benefits and persistence of US-based global bond funds

This paper examines diversification benefits and performance persistence of 188 US-based global bond funds that survived and were defunct during the period of 1993–2004. Consistent with managed fund literature, global funds underperform broad-based benchmark indexes; however, the underperformance is less than the funds’ expense ratio. The results using both simple and time-varying frameworks suggest that global funds provide higher total return and comparable risk-adjusted return to domestic bond funds. For US investors specializing in domestic bond funds, global funds can enhance return by 0.5–1% per year without increasing risk. Global funds also provide incremental diversification benefits to equity fund investors. The funds exhibit short-run performance persistence, but this is difficult for investors to exploit, especially in long-run. Global funds show no return seasonality during the sample period. On a risk-adjusted basis, larger and newer funds and funds with long maturity and low expense ratio perform well.     

Do Retail Trades Move Markets?

We study the trading of individual investors using transactiondata and identifying buyer- or seller-initiated trades. We documentfour results: (1) Small trade order imbalance correlates wellwith order imbalance based on trades from retail brokers. (2)Individual investors herd. (3) When measured annually, smalltrade order imbalance forecasts future returns; stocks heavilybought underperform stocks heavily sold by 4.4 percentage pointsthe following year. (4) Over a weekly horizon, small trade orderimbalance reliably predicts returns, but in the opposite direction;stocks heavily bought one week earn strong returns the subsequentweek, while stocks heavily sold earn poor returns.     

Luck versus Skill in the Cross‐Section of Mutual Fund Returns

The aggregate portfolio of actively managed U.S. equity mutual funds is close to the market portfolio, but the high costs of active management show up intact as lower returns to investors. Bootstrap simulations suggest that few funds produce benchmark‐adjusted expected returns sufficient to cover their costs. If we add back the costs in fund expense ratios, there is evidence of inferior and superior performance (nonzero true α) in the extreme tails of the cross‐section of mutual fund α estimates.     

Trends and determinants of Australian managed fund transaction costs

The present paper examines the often-overlooked managed fund fee that is incurred when investors enter and exit managed fund products. The present paper documents that transaction costs for investors, measured by the application-redemption spread, are above stock market brokerage rates although they have declined since 1995. The study analyses the relationship between this transaction fee and several variables. In summary, retail fund transaction costs are positively related to retail funds’ assets under management, whilst this relationship is negative for larger wholesale funds, consistent with economies of scale. Direct entry and exit fees and initial commissions are positively related to transaction costs which raises the possibility that the commissions are used to levy soft-dollar payments. The paper also documents a relationship between transaction costs and fund flows which differs between retail and wholesale funds. Overall, the findings are consistent with the proposition that the various fees are used by managers as interchangeable and the different fee regimes reflect different products and markets.     

Demand Curves and the Pricing of Money Management

One reason why funds charge different prices to their investorsis that they face different demand curves. One source of differentiationis asset retention: Performance-sensitive investors migratefrom worse to better prospects, taking their performance sensitivitywith them. In the cross-section we show that past attritionsignificantly influences the current pricing of retail but notinstitutional funds. In time-series we show that the repricingof retail funds after merging in new shareholders is predictedby the estimated effect on its demand curve. This result isrobust to other influences on repricing, including asset andaccount-size changes.     

Twitter activity,investor attention,and the diffusion of information

We examine the impact of Twitter attention on stock prices by examining over 21 million company‐specific tweets over a 5‐year period. Through a quasi‐natural experiment identifying official Twitter outages, we find that Twitter influences stock trading, especially among small, less visible securities primarily traded by retail investors. In addition, we determine that Twitter activity is associated with positive abnormal returns and when tweets occur in conjunction with traditional news events, more information is spread to investors. Finally, we show that retail investor activity drives the Twitter effect as institutional investors less actively trade the affected stocks.     

INVESTOR REACTION TO MUTUAL FUND PERFORMANCE: EVIDENCE FROM UK DISTRIBUTION CHANNELS

Existing work on the flow–performance relation in mutual funds focuses on the average U.S. investor, obscuring the contributions of different clienteles. We analyze UK data on monthly fund sales and purchases made via seven distinct distribution channels. We show that there exist marked differences in the reaction to fund performance between different types of retail and institutional investors. These differences can be understood by considering the incentives of parties involved in each channel. Our analysis indicates that the well‐documented aggregate net flow–performance convexity in mutual funds is driven by the extreme reaction of retail inflows to favorable performance, particularly from independently advised investors.     

Do machines beat humans? Evidence from mutual fund performance persistence

We study the performance persistence of quantitative actively managed US equity funds. We show that the persistence of quantitative funds originates from poor performers and that there are reversals at the top of the performance scale, which is no different from the widely accepted evidence in the mutual fund literature. When testing for differences in performance persistence between quantitative and non–quantitative funds, we find no differences for poorly performing funds, but we observe significantly more reversals for quantitative funds at the top of the performance distribution. We also find that the differences in performance persistence are not explained by differences in flow–induced incentives to generate alpha, as there is no heterogeneity in investors preferences when allocating capital to these funds. Overall our results are consistent with machines having less skill than their human counterparts.     

Herding by mutual funds: impact on performance and investors’ response†

In this paper we investigate whether herding by actively managed equity funds affects their performances and flows over the 1980–2013 period. We show that during the herding quarter, on average, funds that trade with the herd benefit from this behavior. Although this does not directly translate into a positive association between the extent to which funds herd and their subsequent performance, we find that the funds that follow the herd earn negative abnormal returns whereas the ones that lead earn no abnormal returns. Our results also indicate that investors react adversely to follower funds while they are neutral towards the leader funds.     

Fool's mate: What does CHESS tell us about individual investor trading performance?

We investigate the short‐term relation between individual investor trading and stock returns on the Australian Securities Exchange. Stocks heavily bought by individual investors underperform stocks heavily sold over the subsequent three days, with respective returns on to a long–short portfolio of ?93, ?67 and ?12 basis points on days one, two and three. Individuals underperform in small and mid‐size stocks when they trade passively using limit orders waiting for the market price to move in their favour. Individuals underperform in large stocks when they trade aggressively using marketable orders. Foreign institutions gain from taking the opposite side of individual trades. We present an information asymmetry‐based explanation for the findings.     

The price of skill: Performance evaluation by households

Skilled investors make money off uninformed investors. By acting as intermediaries, they provide a hedge to the uninformed investors themselves. I present a model in which households have imperfect information about expected returns. Non-traded income shocks lead them to rebalance, sometimes at the wrong time. Active funds hedge this risk by trading on superior information. In equilibrium, they pay off when non-traded income disappoints, earning a premium that makes them appear to underperform index funds after fees. Empirical results using aggregate fund flows support the model. A corresponding asset pricing test can account for the apparent underperformance of active funds.     

International equity funds,performance, and investor flows: Australian evidence

This is the first paper in the Australian literature to examine the investment performance of actively managed international equity funds (domiciled in Australia). Both institutional and retail international equity funds are assessed together with the impacts of investor fund flows on portfolio returns. Performance is also evaluated using conditional measures that account for public information in the global economy, however, despite an improvement in the measurement of risk-adjusted returns, performance remains consistent with an efficient global market. These findings support prior research, which concludes that active management does not provide investors with superior returns to passive indices. When consideration is given to the liquidity service provided by active managers, fund flows are shown to negatively impact on performance.     

On the Choice of Superannuation Funds in Australia

Using a sample of Australian retail and wholesale superannuation funds to proxy for choice and limited choice alternatives, respectively, we investigate the costs and benefits of providing choice to investors. We find that investors who have choice don't respond to fees. Also, loads - typical of the choice environment - are likely to be a dead-weight loss borne by investors. Employees who involuntarily contribute to (employer) funds, tend to pay the lowest fees. Given these results, the advantages of choice become questionable. Our results show that managers of limited choice funds achieve greater positive abnormal returns than retail fund managers. The analysis of flows provides insight into why choice funds do not perform better than limited choice funds. Investors are not responding to historical performance as predicted.     

The Information Content of Australian Managed Fund Ratings

Abstract:  We examine the information content of managed fund ratings for Australian retail investors. Because fund ratings, premised on a quantitative-qualitative model, are highly transitory, we question whether investors formulate their investment decisions with respect to changes in ratings and whether ratings, in turn, react to fund flows. We find that information regarding fund flows can be obtained from ratings, and that rating changes can have far-reaching effects. Investors flock to newly upgraded funds while they penalize those that have been downgraded by withdrawing funds. Investors are constantly anticipating ratings revisions, particularly downgrades, and we attribute this phenomenon to the role of qualitative factors in the ratings.