Performance persistence

As we have seen earlier, selecting and managing a well-diversified portfolio requires time and expertise, and many investors prefer to outsource these activities to professionals. The financial services industry caters for this preference by offering a large variety of mutual and other funds that are easily accessible to small and big investors. The performance of these funds has been the subject of scientific research – and controversy.

Types of funds

Funds can (1) provide different services to their investors, (2) be structured in three dif-ferent ways and (3) have difdif-ferent investment policies. Most funds that are aimed at the general public provide some administrative services to their investors: they keep record of the amounts invested and the income earned. They also enable small investors to hold fully diversified portfolios and to increase or decrease their holdings with small amounts at low transaction costs. In addition, actively managed funds provide their management’s professional expertise to make investment decisions on behalf of the investors. Actively managed funds aim to outperform the market by trying to select stocks with superior performance (stock picking) and/or by trying to buy stocks before a price increase and selling them before a price decrease (timing). By contrast, index funds, or passively man-aged funds, do not aim to beat the market but try to follow a market index as closely as possible. This is done either by buying all the stocks in the index or by buying a smaller number of carefully selected stocks that closely track the index. While actively managed funds compete on performance, index funds compete on cost level and deviation from the index (or tracking error).

A fund can be structured as an open-end fund (or mutual fund), a closed-end fund or a hedge fund.¹⁰ The most important type is the open-end fund. The shares of open-end funds are not traded on exchanges but sold and bought directly by the fund or indi-rectly through brokers. The fund issues new shares when investors want to buy them and redeems shares when investors want to sell them, so there is no fixed number of shares.

Buying and selling takes place at the net asset value, which is the current market value of the assets held by the fund minus liabilities and divided by the number of outstanding shares. Mutual funds may charge an entry and/or exit fee, called front-end load and back-end load. Actively managed mutual funds also claim an annual management fee of 1–2 per cent. The management fees of index funds are much lower, typically 0.2 per cent per year. These are figures for the United States, to which most research refers; the fees in Europe are usually higher.

Closed-end funds issue a fixed number of shares, which are subsequently traded on exchanges. Investors cannot sell the shares back to the fund, they have to sell them to other investors on the exchange. Hence, the share price is determined by supply and demand and can differ from the net asset value. Both open-end and closed-end funds are regulated by the financial authorities because they offer their shares to the public at large. This limits, among other things, their possibilities to borrow, to use derivatives and to sell short.

...

10 In practice, the term ‘mutual fund’ is also used in a more general sense and may refer to both open-end and closed-end funds.

115 4.2 Empirical evidence

The third type of funds, hedge funds, are exempted from most regulations because they do not offer their services to the general public. Hedge funds have only a limited number of investors (≤ 100) or only ‘qualified’ investors who meet certain income or net worth standards. Such investors are assumed to be able to look after themselves. Hedge funds also have a different fee structure. Like other actively managed funds, they charge an annual 1–2 per cent management fee but hedge funds managers also claim an incentive fee of, typically, 20 per cent of the investment gains above a certain threshold. Hedge funds can have lock-up periods, during which investors cannot withdraw money from the fund.

Each fund has its own investment policy: some only invest in fixed income securities (bond funds), others only in stocks (equity funds) or real estate, while still others spread their investments over two or more categories (balanced funds). Within each asset cate-gory, funds can specialize further. Equity funds can concentrate on income stocks, that pay out a large fraction of their earnings as dividends, or growth stocks that retain most earnings. Funds that specialize in geographical areas or industries are also very common.

Many investment companies run a family of funds that includes actively and passively managed funds for several asset categories and specializations. The investment policies of hedge funds are even more diverse and may include the use of short positions and derivatives, as well as (heavy) borrowing.

In the context of market efficiency the important question is, of course, whether active, professional management can systematically generate excess returns. If markets are efficient, deviations from risk-adjusted expected returns are random, which means that neither funds-on-average nor (groups of) individual funds are able to systematically beat the market. These are very strong implications. After all, professional managers are in the best position to generate superior returns: they have access to the latest price infor-mation and the best databases and research tools, and it is their full-time job to search for and analyze information. Fund performance and its persistence is generally analyzed using data from actively managed, open-end mutual funds, since that is the dominant type of fund. In view of the importance of the mutual fund industry (its size in the United States alone is measured in trillions of dollars) it is not surprising that an enormous amount of research has been devoted to this question.

Evidence on fund performance and its persistence

Sharpe (1966) was among the first to examine the performance of mutual funds. Using the return-to-variability ratio, or Sharpe ratio (3.10) discussed in the previous chapter, he ana-lyzes the performance of thirty-four mutual funds over the period 1954–1963. His findings are that the funds, on average, significantly underperformed the Dow-Jones Industrial Average. Twenty-three funds did worse, eleven did better than this index. Sharpe attributes this poor performance to the costs incurred by the funds, because their gross perfor-mance (before subtracting expenses) does not differ significantly from the index. He also finds a modest degree of persistence in the performance of these funds. Similar results are obtained by Jensen (1968), who analyzes the performance of 115 mutual funds in the period 1945–1964 with his own Jensen’s alpha (3.12). He concludes that the funds, on average, were not able to outperform a buy-the-market-and-hold strategy.

Moreover, only three of the funds performed significantly better than the market. Unlike

Sharpe’s conclusions, Jensen’s hold even when the funds’ returns are measured gross of management expenses.

The stream of studies that followed Sharpe’s and Jensen’s seminal papers successively introduced more sophisticated statistical techniques, better and larger databases that are free from survivorship bias, and an international perspective.¹¹Although the question of fund performance remains controversial, the majority of studies report that, on average, actively managed funds underperform the index and index funds. This gives strong sup-port to the efficient market hypothesis. There is also agreement that some funds keep on performing poorly, mainly through excessive trading, and disappear. The remaining con-troversy is whether some funds can consistently outperform the market, i.e. whether some funds are managed by ‘hot hands’ that can generate excess returns.

Using a variety of databases, performance measures and analytical techniques, stud-ies such as Grinblatt and Titman (1992), Hendricks et al. (1993), Brown and Goetzmann (1995), Elton et al. (1996), Droms and Walker (2001) and Bollen and Busse (2005) all report performance persistence, usually combined with average underperformance. The period over which the performance persists varies from a quarter to three years, but is usually short and the persistence decreases with time. Droms and Walker (2001) also analyze the persistence in other fund characteristics than returns and find no persistence in expenses ratios or turnover rates (trading activity). However, the persistence in perfor-mance is contested. Malkiel (1995), using a large database spanning two decades, finds that performance persistence is likely to be influenced by survivorship bias and may be limited to specific periods. He finds strong persistence in the 1970s but none in the 1980s and concludes that most investors would be considerably better off by buying a low-expense index fund than by trying to select an active fund manager with ‘hot hands’.

Carhart (1997) finds only very slight evidence consistent with skilled or informed fund managers and he attributes the ‘hot hands’ effect of Hendricks et al. (1993) to the one-year momentum in stock returns that was described by Jegadeesh and Titman (1993). Dif-ferences in expense ratios and transaction costs also contribute to persistence: the more actively a fund trades, the lower its net return to investors. Similar results are obtained more recently by Cuthbertson et al. (2008) who analyze a comprehensive data set on UK mutual funds. They find performance persistence among poorly performing funds but not among winners.

Wermers (2000) empirically decomposes mutual fund performance into its component parts. He finds that funds hold stocks that outperform a broad market index by 1.3 per cent per year. Of this, 0.6 per cent is due to the fact that mutual funds choose their stocks from a somewhat different universe than the whole market, and 0.7 per cent is due to the funds’

stock picking ability within this universe. The funds show no timing ability. However, mutual funds do not always hold all their money in stocks, they also keep other securities and cash for transaction purposes. These non-stock holdings depress fund performance with 0.7 per cent per year relative to stocks. In addition, the funds incur 1.6 per cent costs per year, in almost equal parts management expenses and transaction costs. The net result

...

11 Taking a sample of existing funds and collecting their performance histories over a certain period overestimates average performance, because the funds that performed so poorly in the period that they ceased to exist are not included. The difference with the true average is called survivorship bias.

117 4.2 Empirical evidence

is an underperformance of 1 per cent per year. The ability of some mutual funds to pick stocks is confirmed by Kosowski et al. (2006), who conclude that a sizable minority of managers is able to persistently generate excess returns that more than cover their costs.

Table 4.6 summarizes the evidence on mutual fund performance. The reviewed studies almost unanimously report that funds, on average, underperform the market. The evidence on performance persistence is mixed. To the extent that persistence in overperformance is found, it appears to be limited to a (narrow) selection of funds and comparatively short periods. Moreover, the excess returns generated by persistence in overperformance are not always worthwhile. For example, both Hendricks et al. (1993) and Bollen and Busse (2005) notice that their results are statistically significant, but economically only marginally better than a naive buy-and-hold strategy. For some (e.g. Malkiel, 2003) these results are the most direct and most compelling evidence of market efficiency.

Table 4.6 Overview of fund performance studies

Average Persistence

underperformance (‘hot hands’)

Sharpe (1966) Yes some (10 years)

Jensen (1968) Yes

-Grinblatt and Titman (1992) - 5 years

Hendricks et al. (1993) Yes 1 year

Malkiel (1995) Yes 1 year (1970s)

No (1980s)

Brown and Goetzmann (1995) Yes 1 year

Elton et al. (1996) Yes 1–3 years

Carhart (1997) Yes No (momentum)

Wermers (2000) Yes

-Droms and Walker (2001) No (1970s) 1–3 years Yes (1980s) No (5+ years)

Bollen and Busse (2005) Yes 3 months

Kosowski et al. (2006) - 1 year

Cuthbertson et al. (2008) - only losers