US Equity Mutual Funds Research Articles

Scale diseconomies and capacity in fund management: variation across equity markets

PurposeWe model the relation between excess returns, fund size and industry size for active equity funds.Design/methodology/approachWe study and contrast four markets – global equities, emerging markets, Australia core and Australia small caps – and use the results to investigate the extent to which funds deviate from estimated capacity.FindingsWe uncover a significantly negative relation between returns and both fund size and industry size across all markets. The estimated percentage of funds operating above versus below capacity varies both across markets and over time, as does the role played by fund size versus industry size. We find a greater prevalence of funds operating significantly below than above capacity, in contrast to findings for US equity mutual funds. Significant deviations from estimated capacity persist for a median of between two and six quarters.Originality/valueOur main contribution is to show that the dynamics governing deviations from capacity for active equity funds vary across markets.

Spotting Portfolio Greenwashing in Environmental Funds

AbstractThis paper examines greenwashing practices in environmental funds. We utilize a unique data set of US equity mutual fund holdings between 2012 and 2021 to calculate the funds’ carbon footprints. Using a difference-in-differences analysis, we find that, following their commitments to sustainability, environmental funds fail to reduce their carbon footprints relative to a matched group of conventional funds. We also find, using an event study, a significant increase in the flows of environmental funds in response to these commitments. The combination of the failure to reduce carbon footprints and the surge in inflows provides evidence of greenwashing by environmental funds, raising concerns about their fiduciary duty. Our findings also show that greenwashers tend to initially have low flows and high portfolio carbon emissions suggesting that they announce their commitments to sustainability just to attract investors.

The power of ethical words

AbstractIn this research, we analyse the impact of the inclusion of ethical expressions in the prospectuses of socially responsible (SR) mutual funds on money flows. We contribute to the existing literature by proposing a text‐based measure that integrates three attributes that are relevant to whether clients are attracted: exclusiveness, intensity and lexical diversity. We analyse a sample formed of 266 SR US equity mutual funds in the period 1999–2019. Our findings show that both the proposed indicator and other alternative partial proxies based on textual data have a positive impact on the money flows of the SR funds. This effect is more relevant in the case of SR mutual funds belonging to smaller families. Besides, persistence in money flows is more intense for SR mutual funds that are more attractive because of their ethical expressions. Another finding shows that return‐chaser behaviour occurs among all SR investors, independently of the level of text attractiveness of the mutual funds in which they invest, revealing that they take into account both financial and non‐financial outcomes. Our results indicate that policymakers should control fund prospectus information, given its importance for investors' decisions. In addition, managers should be especially cautious with the information provided in prospectuses because of its impact on investor decisions.

The paradox of closing mutual funds to new investors.

I provide an explanation for the well-established paradox that mutual funds that close to new investors fail to maintain their pre-closure positive abnormal performance after closing. Using a large sample of active US equity mutual funds, I find that the within-style performance ranks of closed funds revert to the mean as strongly as those of a control group of open funds. Furthermore, I show that funds that are closed do not drastically alter their investment allocations and hold portfolios that are indistinguishable from their portfolios prior to closing in terms of risk-adjusted performance. Therefore, mean reverting stock returns explain the deterioration in fund performance after closing to new investors. I also document that funds are not capable of better preserving their assets when anticipating a decline in performance by closing to new investors and thus adding exclusivity. Furthermore, the control group of open funds does not suffer from excessive flows. Closing to new investors is at best unnecessary from the stand-alone perspective of the fund.

Towards a macroprudential regulatory framework for mutual funds?

AbstractThis paper highlights the procyclical and unstable behaviour of mutual funds, characterized by a varying sensitivity on common asset pricing factors. It proposes a novel factor model that allows for regime changes associated with macroeconomic and financial state variables. Estimated on a panel covering 825 US equity mutual funds over a period of 30 years, it appears that the yield curve, the dividend yield, short term interest rates and the industrial production coincide with regimes switches in the Fama–French factors. Furthermore, the estimated regimes coincide with financial crises and economic downturns, thus confirming the procyclical behaviour of mutual funds' returns. These findings, coupled with the emerging systemic role of mutual funds, promote the consideration for a specific macroprudential regulatory framework targeted at the mutual fund industry.

Performance and diversification benefits of IPO‐focused mutual funds

AbstractWe investigate whether mutual funds that invest in initial public offerings (IPOs) outperform the Renaissance IPO Index, IPOX® 100 U.S. Index, and other comparable equity funds that do not invest in IPOs. We also explore whether investors gain diversification benefits by investing in IPO‐focused mutual funds. Using a sample of active open‐ended US equity mutual funds, we find that IPO‐focused funds outperform the Renaissance IPO Index and comparable funds that do not invest in IPOs. Moreover, they provide investors with the benefit of diversification along with better returns. We also find the value added by active management based on IPO strategy.

Tracking error volatility and relative risk budgets

ABSTRACT This paper uses a pooled cross-sectional sample of actively managed US equity mutual funds from 1991–2022 to show that tracking error volatility (TEV) is characterised by reversion. Mutual funds with relatively high (low) TEV tend to reduce (increase) their TEV in subsequent periods, and the degree of reversion is determined by the degree to which TEV is relatively high or low. This suggests that TEV is managed over time to satisfy relative risk budgets. This paper also shows that the previous literature’s finding that mutual funds increase their TEV as their performance declines holds even when taking into consideration that both performance and change in TEV may be jointly determined by TEV level. The results are robust to a variety of measurement periods and methodologies.

Systematic ESG Risk and Decision Criteria for Optimal Portfolio Selection

The author suggests an alternative environmental, social, and governance (ESG) integration framework for portfolio optimization to reflect that systematic ESG risk can account for joint movement in security prices. The author’s framework consists of the double-index model, the two-layer grouping, and the extended-criteria decision rule for optimal portfolio selection. The author’s approach clearly shows how institutional investors can manage systematic ESG risk, rather than individual ESG risk, during portfolio optimization. The framework also provides a simple decision rule, a practical complement for complicated nonlinear programming algorithms, and clearly shows the security characteristics that make it desirable. Applying the framework to US equity mutual funds indicates that the approach can help investors understand how systematic ESG risk is relevant to future risks or returns, strategically manage systematic ESG risk, and improve the portfolio’s risk-adjusted return. Thus, the author’s framework can provide a tractable empirical method compatible with recent theoretical analyses on ESG factor investing.

Are investors aware of climate-related transition risks? Evidence from mutual fund flows

Using information on climate transition risks embedded in US equity mutual fund portfolios, we report evidence that mutual fund investors consider climate-related transition risk to be an undesirable fund feature and accordingly allocate more money to funds with lower climate-related transition risk. The size of the impact of this risk on fund flows differs depending on the performance expectations of investors and the socially responsible focus and sustainability of the fund. Our results suggest that mutual fund investors are aware of climate-related transition risks as evidenced by their investment decisions.

On management risk and price in the mutual fund industry: style and performance distribution analysis

This study shows how investing in mutual funds involves an additional risk, which we call management risk as a consequence of the uncertainty in the results of active management. To address this issue, we analyze a sample of 2539 US equity mutual funds. For comparative purposes, we differentiate among index funds and actively managed mutual funds with different investment styles. We observe that performance distribution shows negative mean, negative skewness, and excess kurtosis. Results also show that management risk is not rewarded with higher abnormal performance. Moreover, higher active management prices are linked to funds with higher management risk and negative asymmetry. Therefore, investors seem to be risk-seeking since they are paying more to participate in high asymmetric bets. Finally, we attempt to solve this puzzle from the behavioral finance perspective.

Vulnerable asset management? The case of mutual funds

Is the asset management sector a source of financial instability? This paper develops a macroprudential stress test model which enables the quantification of systemic vulnerabilities due to fire sales in this sector. The model incorporates the flow-performance relationship as an additional funding shock in the model of Greenwood et al. (2015). Using data on US equity mutual funds for the period 2003–14, we quantify both fund-specific and system-wide (aggregate) vulnerabilities to fire sales over time. Our main finding is that the aggregate vulnerability, according to this propagation mechanism, is relatively small in comparison with values reported for banks. However, during periods of low market liquidity, the vulnerability of the system can become significant. Our paper also contributes to the ongoing discussion on the SIFI designation of Non-Bank Non-Insurer entities. For this purpose, we explore the determinants of individual funds’ vulnerability to systemic asset liquidations, highlighting the importance of size and portfolio illiquidity. Therefore, regulators should monitor structural vulnerabilities in the fund sector arising through liquidity transformation.

Toward ESG Alpha: Analyzing ESG Exposures through a Factor Lens

Using data on 1,312 active US equity mutual funds with $3.9 trillion in assets under management, we analyzed the link between funds’ bottom-up, holdings-based environmental, social, and governance (ESG) scores and funds’ active returns, style factor loadings, and alphas. We found that funds with high ESG scores have profiles of factor loadings that are different from those of low-scoring ESG funds. In particular, funds with high environmental scores tend to have high quality and momentum factor loadings. In partitioning the ESG scores into components that are related to factors and idiosyncratic components, we found strong positive relationships between fund alphas and factor ESG scores.

Are Investors Aware of Climate-Related Transition Risks? Evidence from Mutual Fund Flows

Using information on climate transition risks embedded in US equity mutual fund portfolios, we report evidence that mutual fund investors consider climate-related transition risk to be an undesirable fund feature and accordingly allocate more money to funds with lower climate-related transition risk. The size of the impact of this risk on fund flows differs depending on the performance expectations of investors, the socially responsible focus and the sustainability of the fund. Our results suggest that mutual fund investors are aware of climate-related transition risks as evidenced by their investment decisions.

Practical Applications of Active Management in Defined Contribution Plans

Practical Applications Summary In Active Management in Defined Contribution Plans, which appeared in the Spring 2020 edition of The Journal of Retirement, Gerald W. Buetow, Jr. (of BFRC Services), Bernd Hanke (of Global Systematic Investors), and Maxim Zagonov (of Toulouse Business School) investigate the value of active management of defined contribution (DC) plans, given that many fiduciaries and most plan participants are not investment professionals. They find that for most DC fiduciaries, it is preferable to replace active US equity mutual funds with low-cost passive alternatives. They attribute this to three reasons: (1) the performance of active managers is inconsistent; (2) there are two levels of decision makers, fiduciaries and plan participants, which complicates effective active fund selection; and (3) the few consistently outperforming funds that exist tend to have higher tracking error, which makes asset allocation more complicated. Therefore, the authors argue, fiduciaries and DC plan participants should select passive rather than active funds. TOPICS:Wealth management, retirement, mutual fund performance, passive strategies

Evidence on the Performance of Infrastructure Mutual Funds

This article investigates, empirically, whether infrastructure-focused mutual funds provide superior performance (higher alphas) than comparable equity mutual funds not investing in infrastructure. Using monthly returns on US equity mutual funds, the “best clientele performance measure” developed by Chretien and Kammoun (2017, 1583), and the generalized method of moments estimation, we find that infrastructure-focused mutual funds have higher alphas (higher best clientele alphas) than comparable funds not investing in infrastructure. Our results support the growing belief that infrastructure-focused equity mutual funds are able to provide superior performance resulting from the financial characteristics of infrastructure. Furthermore, our results show that the investor disagreement about the performance of infrastructure-focused equity mutual funds is not significantly different from that of comparable funds not investing in infrastructure. TOPICS:Wealth management, mutual fund performance Key Findings • The infrastructure-focused equity mutual funds have higher alphas (higher best clientele alphas) than comparable funds not investing in infrastructure. • The investor disagreement about the performance of infrastructure-focused equity mutual funds is not significantly different from that of comparable funds not investing in infrastructure. • Our results support the growing belief about the superior performance of infrastructure-focused equity mutual funds resulting from the financial characteristics of infrastructure.

Active Management in Defined Contribution Plans

We analyze the problem that fiduciaries face when monitoring and selecting from a universe of active mutual funds within a defined contribution (DC) plan. In a DC plan, a fiduciary must recognize that there are two levels of decision makers, namely, the fiduciary, who decides which funds will compose the DC plan, and the individual plan participants, who must decide which funds to invest in and the timing of their investment. Moreover, plan participants, and to some degree the fiduciary, need to be able to make investment decisions without being investment professionals. We find that due to the general lack of consistency in performance of mutual funds, fiduciaries and plan participants would be better served by selecting passive rather than active funds across the US equity mutual fund space. Moreover, the most consistently outperforming funds tend to have meaningfully higher tracking errors relative to their stated benchmarks, which makes effective asset allocation in a DC plan more difficult. TOPICS:Wealth management, retirement, mutual fund performance, passive strategies Key Findings • There are two levels of decision makers in defined contribution (DC) plans—fiduciaries and plan participants—and this complicates active fund selection. • Most DC fiduciaries would be better served by replacing active US equity mutual funds with low-cost passive alternatives for both wealth aggregation and performance consistency reasons. • Consistently outperforming active funds are rare and tend to have higher tracking error, which makes asset allocation more complicated.

Does the choice of fund performance measure matter?

ABSTRACTThis paper investigates whether investment strategies using rankings based on different portfolio performance measures lead to different future abnormal returns. A set of 13 commonly used risk-adjusted performance measures is applied to a dataset of US equity mutual funds over the period July 1970 to September 2019. The results show some evidence of short-term performance persistence, suggesting that portfolios formed on different performance measures ex-ante can generate abnormal returns ex-post. A strategy of investing in the top performing funds and shorting the poor performing funds provides positive excess returns and five-factor alphas. However, when adjusting for the momentum factor, there is less evidence of abnormal performance. The results also show that overall there is little difference arising from the use of different performance measures, but with one notable exception: the Rachev ratio.

ESG-Screening and Factor-Risk-Adjusted Performance: The Concentration Level of Screening Does Matter

Constructing ESG-screened portfolios aims to reduce the aggregate ESG-risk at the portfolio level by excluding low ESG-score constituents from the selection universe. But ESG-screening imposes limits on potential diversification as well as alters risk exposures to systematic factors. To investigate ESG-screening’s impact on the factor-risk-adjusted performance of portfolios, we construct ESG-screened portfolios consisting of US equity mutual funds according to their returns-based ESG-scores. The result of performance contribution analysis for the sample period from 1999 to 2018 suggests that investors need to treat the concentration level of ESG-screening as a search parameter to balance the costs and benefits of ESG-screening.

Correction to: Benchmark-adjusted performance of US equity mutual funds and the issue of prospectus benchmarks

After publication in Vol 20 Issue 1, it was noticed that the affiliations of authors Irina Bezhentseva Mateus and Cesario Mateus were incorrectly given as Cass Business School, City, University of London, London, UK.

中美市场的长期α与β (The Long Term α and β of Chinese and US Market)

Chinese Abstract: 本文对比了中国与美国股票市场的长期β与α。实证结果显示，从长期来看，美国股市全市场的β在6%-7%之间，中国股市全市场的β在5%左右。相比中国市场，美国股市的β更高，波动率更低。美国股票型共同基金的年化超额收益α在-1%至-2%之间。美国市场高度成熟，早在1945年-1965年期间，股票型共同基金就已经无法在市场上获得超额收益α了。中国市场的年化β为6.53%，同期普通股票型公募基金的年化α为4.78%，偏股混合型公募基金的年化α为2.98%。相比高度成熟的美国市场，机构投资者仍可以在中国市场上获得超额收益。 English Abstract: This paper compares the long-term β and α of the Chinese and US stock markets. The empirical results show that in the long run, the β of the US stock market is between 6% and 7%, and the β of the Chinese stock market is around 5%. Compared with the Chinese market, the US stock market has a higher β and a lower volatility. The annualized excess return α of US equity mutual funds is between -1% and -2%. The US market is highly efficient: as early as 1945-1965, stock mutual funds were unable to obtain excess returns. The annualized β of the Chinese market is 6.53%. In China, the annualized α of stock mutual funds is 4.78%, and the annualized α of blended mutual funds is 2.98%. Institutional investors can still get excess returns in the Chinese market compared to the highly efficient US market.