Active Fund Managers Research Articles

Measuring bond mutual fund performance with portfolio characteristics

Abstract This paper studies the performance of U.S. bond mutual funds using measures constructed from a novel data set of portfolio weights. Active fund managers exhibit outperformance before costs and fees generating, on average, gross returns of 1% per annum over the benchmark portfolio constructed using past holdings (approximately the same magnitude as expenses and transaction costs combined). This suggests that fund managers are able to earn back their fees and costs. There is evidence of neutral ability to time different portfolio allocations (sector, credit quality, and portfolio maturity allocations) and only a subgroup of bond funds exhibit successful timing ability. One performance measure based on portfolio holdings predicts future fund performance and provides information not contained in the standard measures. These results provide the first evidence of the value of active management in bond mutual funds.

Failure to Delegate

This paper documents a sharp reversal of individual investors' tendency to delegate their equity investments between 2007 and 2011, primarily based on a representative sample of 40,000 self-directed clients at one of Germany's largest retail banks. At the beginning of 2007, the typical sample investor holds 44% of his equity investments in stock funds; at the end of 2011, this fraction has dropped by about half. Much of the drop occurs at the height of the 2008 and 2011 financial crises, implying that investors take on idiosyncratic risk precisely when equity market volatility peaks. The failure to delegate is not special to the sample; it can also be detected in the broader German investor population and among U.S. households. The failure to delegate is costly: sample investors who tilt their equity portfolio towards individual stocks experience returns that are 25% more volatile and 2% per year lower, on average, than had they simply held on to their more delegated portfolios. The explanation for the decline in delegation that appears to be most consistent with the data is that investors perceive opportunities in individual stocks during the recent financial crises, but do not trust active fund managers to exploit these opportunities on their behalf.

When Fund Managers Distinguish Themselves from the Herd: How Stock Correlations Affect Portfolio Returns.

An important component of the asset allocation decision is the timing of any changes to the portfolio weighting. I provide evidence that excess returns from actively managed mutual funds are higher when active fund managers react to prior month stock correlations to make their allocation decision. Fund managers that react to these conditions significantly outperform the benchmark index and are making changes in the ‘activeness’ of their portfolio. My results have important implications for asset management as investors move more funds to actively managed funds when systematic risk is low, which happens to be the time when those same funds perform better relative to their passive peers.

Moral Hazard in Mutual Fund Management: The Quality-Assuring Role of Fees

Active fund managers implicitly promise to research profitable portfolio selection. But active management is an experience good subject to moral hazard. Investors cannot tell high from low quality up front and therefore fear manager shirking. We show how the parties mitigate the moral hazard by paying the manager a premium fee sufficiently high that the manager’s one-time gain from shirking is less than the capitalized value of the premium stream he earns from maintaining his promise to provide high quality. Premium advisory fees act as a quality-assuring bond. Our model has a number of revealing extensions and comparative statics.

Low Risk Anomaly Everywhere - Evidence from Equity Sectors

We give strong empirical evidence of a risk anomaly in equity sectors in a number of regions and countries of developed and emerging markets, with the lowest risk stocks in each activity sector generating higher returns than would be expected given their levels of risk, and the converse outcome for the riskier stocks. We believe this evidence is a likely consequence of the fact that equity analyst and active fund managers tend to specialize in particular sectors and to mainly select stocks from those sectors. Additionally, constraints restricting the deviation of sector weights in active portfolios against their market capitalization benchmarks are often used by active fund managers, in particular by quantitative managers which tend to go as far as being sector neutral. As a consequence, we find that sector-neutral, low-risk approaches appear more efficient at generating alpha than non-sector neutral approaches, with the latter showing strong sector allocation towards financials, utilities and consumer staples than sector neutral, at least when applied to developed countries in a global universe. We also discuss some properties of low-risk investing such as tail risk, turnover and liquidity.

Value of waiting – option pricing as a tool for residential real estate fund divestment management

Purpose– The value of waiting to invest has been acknowledged in management of real capital investments. Investment decision should be undertaken only if it can justify giving up the value of the option to wait; the same logic is proposed here to be applicable on divestment management of a real estate fund. The purpose of this paper is to test option pricing to quantify the option to wait in a residential real estate fund divestment. It is argued that standard industry valuation practices miss the value of active fund management that should be included when planning a fund divestment strategy.Design/methodology/approach– Dynamic programming, specifically binomial option-pricing model is suggested to complement the current industry standard valuation approaches. The approach is tested in an embedded case study where assets of a residential real estate fund are valuated using the model.Findings– Option pricing can provide risk-neutral quantified value whether an apartment building portfolio should be divested in a single transaction or in multiple transactions over time. In the case study, an option value of 6.6 per cent was found for a residential real estate portfolio.Originality/value– This study is the first of its kind to propose that value of waiting to divest is an important element when planning a real estate fund divestment. The approach proposed in this study risk-neutrally calculates the value appreciation from the range of the potential values. This provides the decision-maker a deeper understanding of the implications regarding the chosen line of action.

International diversification among Islamic investments: is there any benefit

Purpose – The purpose of this paper is to assess the benefits to investors of international diversification among only Islamic funds. Compared to conventional investors who are not restricted in their choice of funds, Islamic investors are restricted to investing in shari’a-compliant funds, thus giving up some diversification benefits. The possibility of international diversification among only Islamic funds may thus help Islamic investors to invest in accordance to their religious beliefs and still benefit from diversification. Design/methodology/approach – The paper assesses the benefits of diversification by analyzing the extent of co-integration among four regional Islamic funds and by estimating the short-term and long-term structural dynamics of and among these funds. The paper uses an Autoregressive-Distributed Lag (ARDL) approach to testing the long-run relationships among these funds and use variance decomposition and impulse response functions to examine the structural dynamics of the relationship between these funds. These methods can also be used for predictive purposes and represent, in authors opinion, a useful approach that complements the traditional methodology of static covariance matrix to find the efficient frontier at a given moment in time. Findings – The results indicate that international diversification can help reduce risk if Asia Pacific Islamic funds and MENA region Islamic funds are invested contemporaneously and/or Asia Pacific Islamic funds and North America Islamic funds, and/or Europe funds and MENA funds. The paper also finds that investors would benefit from investing in North American funds and MENA funds both in the long run and in the short run. Conversely, the paper finds that Europe funds and North American funds are co-integrated in the long-run precluding the opportunity for substantial diversification benefits from these particular portfolio mixes. Research limitations/implications – The long-run analysis helps passive fund managers and investors in composing their portfolio by providing evidence that some portfolio mixes of different regional Islamic funds lead to better risk return performance than one regional Islamic fund portfolios. The short-run analysis however helps the active fund managers and investors as it suggests that diversifying in the short run and reviewing their portfolio on a regular basis would be beneficial as well. Originality/value – This analysis justifies the promotion of Islamic finance as the negative correlation between several Islamic funds across the regions studied suggests better opportunities of investments via international diversification making Islamic funds more desirable.

An Equity Portfolio Framework for CombiningActive Management and Index-Based Implementation

The proliferation of liquid, transparent, and inexpensive index-based implementation means that nearly all types of investors, individual and institutional, face a persistent portfolio implementation question regarding the allocation between active managers and index-based strategies. Placing active risk from active fund management in the same framework of uncertainty that asset allocators utilize for other portfolio decisions brings to the active versus passive debate a surprising and enlightening answer that does not match typical discourse on the matter. Instead of a binary, “all or none” answer, reasonable (and even optimistic or pessimistic) expectations for active management imply a balanced implementation approach. Only extreme assumptions (e.g., very positive or negative levels of active return, very short or long time horizons) indicate a binary choice. <b>TOPICS:</b>Mutual funds/passive investing/indexing, portfolio construction, equity portfolio management

Differences in Short-Term Performance Persistence by Mutual Fund Equity Class

To consistently earn positive alpha, active fund managers must have access to mispriced stocks. We show that mispricing varies by equity class in such a way that greater mispricing occurs in smaller-cap and more value-oriented stocks, providing opportunity for managers in these classes. Accordingly, we find the greatest evidence that top-performing mutual fund managers continue to earn positive alpha in smaller-cap and more value-oriented classes when investigating quarterly performance persistence by equity class. Conversely, large cap funds show no evidence of persistence in superior performance. In contrast to the patterns of persistence in superior performance, relative performance persists in all equity classes.

Investor Cash Flow and Mutual Fund Behavior

We study the behavior of a mutual fund manager in a discrete‐time model, in which new investors may choose to invest in the fund after the fund manager has made trading decisions. We show that under certain conditions the fund manager may choose to buy overvalued assets at the expense of the investors in order to attract new investments, who would otherwise not invest in the fund. This can potentially lead to higher risky asset prices and a higher‐than‐optimal proportion of investment in risky assets in the active fund management industry.

Performance implications of active management of institutional mutual funds

We use information on institutional US mutual funds to examine the performance implications of the decisions they make when actively implementing their investment processes. Our findings show that the success of active fund managers' stock selection decisions is influenced both by the aggressiveness with which they implement their processes and also the style tilts incorporated into their active positions. Our findings provide useful insights into both where one might best look when choosing an active manager and also suggest possible profitable investment strategies.

Is There Alpha in Institutional Emerging-Market Equity Funds?

Can active fund managers outperform the passive index in the global emerging-markets equity arena? To answer this question, the author delineates emerging-market fund strategies and applies multifactor approaches to a unique data set, consisting of institutional emerging-market managers’ returns from Russell Investments. This analysis produced five major findings from January 1997 to June 2011: 1) product varieties have proliferated in this asset class; 2) active management can work in this asset class, but investors have relied more on research to hire good managers; 3) value managers tend to have higher alphas historically, but the supply of value managers is smaller than that of growth-or market-oriented managers; 4) price momentum, valuation, Asia, and the resources sector are key risk drivers; and 5) active risks from this asset class are still present, so it’s important to diversify across multiple strategies and styles to mitigate unwanted risks. Alphas are obtainable, but they are not free. <b>TOPICS:</b>Equity portfolio management, in markets, exchanges/markets/clearinghouses

Against the Odds: Actively-Managed Funds in Defined Contribution Plans

Active managers are employed heavily in Defined Contribution (“DC”) plans. This suggests that plan sponsors believe that (1) participants know how “to use” an active manager properly, and (2) that active managers contribute to participant retirement security. In this paper, it is argued that the assumption that participants know when and how to “use” an active manager is mistaken. Additionally, information is reviewed that indicates strongly that active management has failed to enhance participant retirement security. Overall, the evidence is appalling; most professionally-advised pension funds would not be caught dead using many of the managers to which DC participants are subjected. The question for the investment profession and for plan sponsors is, why do we allow participants to invest this way?

Performance Evaluation, Contracts, and Flows in Efficient Markets

A common misconception in nance is that investors who believe in an efcient market will not invest with an active fund manager. In this paper I develop a model of active money management in which both the investor and the fund manager believe that the market is ecient and that all assets are fairly priced. Furthermore traditional performance measures would not be positive for the manager. But despite this the investor still nds it desirable to invest with the manager. The model yields equilibrium contracts, performance measures, and performance/ow relationships that conform with those we observe in the mutual fund industry.

The Economic Implications of the Department of Labor's 2010 Proposals for Broker-Dealers

In 2010, the U.S. Department of Labor proposed changes that would eliminate third-party incentive payments, such as 12b-1 fees, that may encourage broker-dealers to sell high-fee mutual funds to Individual Retirement Account (IRA) customers. The investment industry argues that eliminating these fees could force broker-dealers to charge directly for advice, which could result in less advice being provided and customers making poor investment decisions. This paper examines the tradeoff between lower fees and investor mistakes due to forgoing advice. The analysis draws on existing pricing and cost evidence from the United States and on the experience of ongoing reforms in the United Kingdom aimed at lowering fees and improving investment advice. An educated guess suggests that the elimination of 12b-1 fees would reduce IRA customer costs by 4 basis points. If broker-dealers responded by moving customers away from high-cost, actively-managed funds into low-cost index funds, IRA customers could save another 7 basis points. Additional savings might be possible to the extent that actively-managed funds underperform their relevant indices. It is unlikely that broker-dealers would change their business model with respect to the provision of advice as a result of the loss of 12b-1 fees. The paper also uses an inter-temporal optimization model to quantify the potential benefits and costs of reform in the United States. The results of the optimization exercise point to relatively modest potential benefits, but even more modest costs under plausible assumptions. Given the size of the policy problem, several more extensive reforms should be considered to ensure that retirement saving in tax-advantaged accounts is invested more effectively. These ideas include: making it easier to retain accumulated assets in the 401(k) system; 2) making the rollover from a 401(k) to an IRA an ERISA-covered event; 3) extending ERISA to all rollover IRAs; and 4) instituting changes to further control fees in both 401(k)s and rollover IRAs.Full paper available in The Journal of Retirement

Outperformance, Underperformance and Mutual Fund Flows in up and down Markets

Closet indexing is the practice of staying close to the benchmark index while still maintaining to be an active mutual fund manager and probably also charging fees similar to those of truly active managers. Recent work shows active mutual fund managers were much more likely to closet index during down markets. Indeed, closet indexing became so popular that it accounted for about a third of all mutual fund assets during time surrounding 2008. In this paper we set out to answer the question of whether there actually is an incentive for mutual fund managers to closet index during down markets. To do this we examine the relationship between annual fund performance and subsequent annual fund flows in both up and down markets. Using this approach we find that the relationship between fund performance and subsequent net fund flows is significantly different in up markets years as compared to down market years. Specifically, we find that fund performance does not drive subsequent flows nearly as much in down markets as it does in up markets. Indeed, in up markets, we find a strong positive relationship between fund performance and subsequent flows. Conversely, in down years, the amount of outperformance or underperformance does not significantly influence the next year’s fund flows. Hence, based on these results, there is an incentive for active managers to closet index in down markets as investors do not reward outperformance with higher flows.

The Impact of Idiosyncratic Risk on Mutual Fund Fees

In the context of a theoretical model for the interaction between an active fund manager and a risk-averse investor, we show that mutual fund fees should exhibit a positive concave dependence on their idiosyncratic volatilities. The crucial ingredients are the infeasibility of short-selling the fund, and the fact that its idiosyncratic volatility generates uncertainty about its performance. Our empirical investigations provide strong support for this result. In fact, idiosyncratic volatility appears to be the most important determinant of mutual fund fees. Moreover, we demonstrate that when it is included as an explanatory variable in cross-sectional regressions, the widely-reported negative dependence of fees on performance dissipates. Significantly, our resolution for this puzzle does not require assumptions of investor unsophistication or fund manager opportunism. In fact, we provide positive evidence for a certain amount of investor sophistication, by demonstrating their apparent unwillingness to pay active fees for passive performance, as predicted by our model.

A Simple Diversified Portfolio Strategy

We present a simple portfolio construction approach which is a blend of market weights and equal stock and sector weights. Our approach results in a highly diversified portfolio both on a stock level and on a sector level and generates higher portfolio returns at slightly lower risk than a market weighted index. We demonstrate that the higher returns of our diversified portfolio originate both from mitigating the link with market weights and from its higher return benefit due to diversification which we are able to capture because we rebalance our portfolio on a regular basis. Our diversified portfolio exhibits only slightly higher turnover than a market weighted index and is less concentrated in mega-cap stocks. Instead it assigns somewhat higher weight to smaller stocks and sectors than a market weighted index. At the same time the diversified portfolio retains the characteristics of a broad market index and is therefore highly implementable and has very high investment capacity.Our simple diversification strategy appears to be a superior way of capturing the equity risk premium compared to a market weighted portfolio. It therefore establishes a tougher benchmark for active fund managers than market weighted indexing as it results in well-diversified, high-capacity and low turnover portfolios that can be delivered very cheaply.

When active fund managers deviate from their peers: Implications for fund performance

This paper proposes that the extent to which mutual fund managers’ beliefs deviate from the ex ante unobservable representative beliefs of their peers contains information about their skill. A new measure based on portfolio allocations, peer deviation, is used to capture a fund manager’s divergence from the contemporaneously unobservable beliefs of her peers. The portfolio based on representative beliefs of a group of managers investing in similar assets outperforms passive benchmarks, indicating that they reflect informed beliefs. Fund managers who simultaneously arrive at portfolio selections which, in hindsight, are close to those implied by representative beliefs possess ex ante more skill and exhibit future outperformance. Copycat strategies replicating lagged portfolio holdings implied by representative beliefs outperform the actual portfolio holdings of funds that deviate most, but the outperformance dissipates after two quarters.

A Stochastic Portfolio Perspective on Utilizing Active and Passive Fund Management

The proliferation of liquid, transparent, and inexpensive index-based implementation means that investors of nearly all types of investors, individual and institutional, face a persistent implementation question: how much passive and how much active?Placing active fund management in the same framework of uncertainty that asset allocators utilize for other portfolio decisions provides a surprising and enlightening answer to the active vs. passive debate that does not match typical discourse on the matter. Instead of a binary “all or none” answer, reasonable (and even optimistic or pessimistic) expectations for active management imply a balanced implementation approach. Only extreme assumptions (e.g. very positive or negative levels of active return, very short or long time horizons) indicate a binary choice.