Mutual Fund Performance and Performance Persistence (eBook)

Dr. Peter Lückoff was a research associate at the Center for Finance and Banking at the University of Giessen (Professor Wolfgang Bessler), a junior research fellow at the Pensions Institute of Cass Business School, London, and a visiting research fellow at Exeter University Business School.

Foreword 6
Preface 8
Contents 10
List of Tables 17
List of Figures 20
Introduction 22
Motivation and Relevance 22
Objective and Structure 26
Part I Delegated Portfolio Management 32
1 Institutional Setting 32
1.1 Role of Mutual Funds 34
1.2 Objectives of Investors 43
Professional Management 43
Diversification 45
Liquidity 46
Additional Services 46
1.3 Investment Strategies 47
1.3.1 Return Predictability and Equilibrium Considerations 47
1.3.2 Active versus Passive Investing 54
1.3.3 Specific Investment Strategies 60
1.3.3.1 Indexing and Enhanced Indexing 60
1.3.3.2 Fundamental Indexing 65
1.3.3.3 Active Long-Only Strategies 66
1.3.3.4 Active Long-Short Strategies 68
1.3.3.5 Activist Investors 69
1.4 Organizational Design 71
1.4.1 Open-End Funds 74
1.4.2 Exchange-Traded Funds 83
1.4.3 Retail Structured Products 85
1.4.4 Closed-End Funds 88
1.4.5 Hedge Funds 89
1.4.6 Comparison of Different Structures 91
1.5 Discussion 95
2 Agency Conflicts 97
2.1 Potential Conflicts of Interest 98
2.1.1 Investors and Portfolio Managers 2.1.1.1 Career Concerns and Tournaments Tournament Behavior 100
Strategic Interaction and Family Tournaments 103
Further Empirical Evidence and Statistical Issues 104
2.1.1.2 Herding 105
2.1.2 Investors and Investment Management Companies 107
2.1.2.1 Distribution Channels and Advertisement Brokers and Financial Advisors 107
Advertising Performance 109
Changing Names and Pretending Innovation 110
2.1.2.2 Fund Families and “Star” Managers Strategically Boosting Fund Performance 111
Side-by-Side Management 113
Strategically Starting, Merging and Closing Funds 113
2.1.2.3 Benchmark Gaming and Performance Manipulation Benchmark Gaming 116
Portfolio Pumping 118
Window Dressing 119
2.1.3 Costs and Potential Third-Party Benefits 120
2.1.3.1 Costs 121
2.1.3.2 Directed Brokerage and Soft Dollars 122
2.1.3.3 Market Timing and Late Trading Market Timing 124
Late Trading 125
2.1.4 Discussion 126
2.2 Potential Solutions for Reducing Agency Conflicts 127
2.2.1 Investment Strategy and Instruments 129
2.2.2 External Governance 2.2.2.1 Transparency and Competition 131
2.2.2.2 Market-Based Control 133
2.2.3 Internal Governance 137
2.2.3.1 Fund Board 138
2.2.3.2 Manager Changes 140
2.2.3.3 Optimal Fund Size 143
2.2.4 Incentive Contracts and Ownership Structures 144
2.2.4.1 Performance-Based Compensation 144
2.2.4.2 Ownership Structures 148
2.2.5 Discussion 152
Part II Investment Performance 154
3 Performance Measurement 154
3.1 Choice of the Correct Performance Measure 155
3.1.1 Asset Class and Investment Strategy 157
3.1.2 Existing Portfolio 158
3.1.3 Chronological Focus 159
3.1.4 Institutional Setting 159
3.2 Ratio-Based Performance Evaluation 160
3.2.1 Information Ratio and Sharpe Ratio 161
3.2.2 Treynor Ratio 162
3.2.3 Ratios for Non-Normally Distributed Returns 162
3.3 Risk-Based Performance Evaluation 165
3.3.1 Jensen Model 167
3.3.1.1 Benchmark Problem 169
3.3.1.2 Time Variability 171
3.3.1.3 Statistical Problems 174
3.3.2 Multifactor Models 176
3.3.2.1 Fama-French Model: Size and Value Effect 176
3.3.2.2 Carhart Model: Momentum Effect 178
3.3.2.3 Construction of Factor-Mimicking Portfolios 180
3.3.3 Timing Models and Conditional Performance Evaluation 184
3.4 Interpretation of Multifactor Models 187
3.4.1 Risk-Based Explanations 3.4.1.1 Time-Varying Asset Composition 188
3.4.1.2 Macroeconomic Risk, Business Cycle and Default Risk Macroeconomic Risk and the Business Cycle 191
Default Risk 192
3.4.1.3 Foreign Exchange Risk 193
3.4.1.4 Liquidity Risk 193
3.4.1.5 Higher Moments and Downside Risk Higher Moments 197
Downside Risk 198
3.4.1.6 Idiosyncratic Risk 199
3.4.2 Behavioral Explanations 201
Extrapolation 202
Underreaction 202
Overreaction 203
Overconfidence 203
Discussion 204
3.4.3 Microstructure Effects 204
Transaction Costs 204
Short Sale Constraints 206
Trading Volume 206
Analyst Coverage 207
3.4.4 Methodological Issues 207
Micro Caps 208
Migration 208
Delistings 209
Industry Effects 210
3.4.5 Statistical Issues 210
Data Snooping and Estimation Error 211
Time Variability 211
Spurious Regression 212
3.4.6 Discussion 212
3.5 Portfolio-Information-Based Performance Evaluation 213
3.5.1 Characteristic-Based Models 215
3.5.2 Holdings-Based Models 219
3.5.3 Trade-Based Models 221
3.6 Improved Statistical Methods 222
3.6.1 Bootstrapping 222
3.6.2 Bayesian Approach 223
3.6.3 Daily Data 228
3.6.4 Controlling for Cross-Correlation 228
3.7 Empirical Results on Active Mutual Funds 229
3.7.1 Fund Performance 229
3.7.2 Investor Performance 232
3.7.3 Implications for Active Mutual Fund Management 235
3.8 Cross-Sectional Performance Determinants 240
3.8.1 Managerial Skill and Information-Related Determinants 3.8.1.1 Investment Style Portfolio Turnover 241
Active Share 244
Portfolio Concentration 244
Style Consistency 246
3.8.1.2 Information Access Financial Centers and Regional Proximity 246
Political Proximity 248
Information Networks 248
3.8.1.3 Manager Characteristics Education 249
Experience 250
Gender 250
Management Structure 251
3.8.2 Cost-Related Determinants 251
Fees 252
Transaction Costs 253
Taxes 255
3.8.3 Fund-Related Determinants Fund Size and Fund Family Size 256
Fund Age 258
Regulatory Environment 259
3.9 Discussion 260
4 Dynamic Aspects of Mutual Fund Performance 262
4.1 Performance Persistence and Predictability 264
4.1.1 Performance Persistence 264
Fees 265
Stock Return Momentum 265
Competition 266
Other Predictable Patterns 267
4.1.2 Potential Data Biases Survivorship Bias 268
Look-Ahead Bias 269
Potential Treatment 270
4.1.3 Methodological Aspects Test Methodologies 270
Ranking Measures 270
Evaluation Measures 273
4.1.4 Potential Model Biases Investment Style 274
Omitted Factors 275
4.1.5 Discussion 276
4.2 Performance-Flow Relationship 277
4.2.1 Characteristics of Fund Flows 277
4.2.2 Performance-Flow Relationship 279
Family Effects 280
Evidence from Other Investment Products 281
4.2.3 Shape of the Performance-Flow Relationship 282
Behavioral Issues 283
Internal Governance and Strategy Changes 284
4.2.4 Impact of Costs and Brokers on Fund Flows Costs 284
Clientele Effects 286
Broker Advice 289
4.2.5 Speed of Reaction 291
4.2.6 Evidence from Gross Flows 292
Gross Inflows 292
Gross Outflows 293
Time Period 294
4.2.7 Discussion 295
4.3 Fund Flows as Equilibrium Mechanism 296
4.3.1 Cash Position Cash Drag 301
Unintentional Beta Variation 301
4.3.2 Transaction Costs and Distorted Security Selection Transaction Costs 302
Distorted Security Selection 304
4.3.3 Ownership Price Pressure 306
Position Liquidity 308
4.3.4 Market Capitalization 309
Investment Style 309
Asset Liquidity 310
Information Advantage 311
4.3.5 Portfolio Concentration 311
Best Ideas 312
Hierarchy Costs 313
Fund Family Response 314
4.3.6 Discussion 314
4.4 Manager Changes as Equilibrium Mechanisms 316
4.4.1 Winner Funds 317
4.4.2 Loser Funds 318
4.4.3 Empirical Results 319
4.4.4 Interaction with Fund Flows 320
4.5 Approaches to Reduce the Detrimental Impact of Flows on Performance 321
4.5.1 Redemption Restrictions Lock-up Periods, Redemption Notice Periods and Gates 322
4.5.2 Fee Structure Load Fees and Redemption Fees 325
Trailer Fees 327
Performance Fees and High-Water Marks 327
4.5.3 Creation Restrictions Soft Closing 328
4.5.4 Trading and Pricing Mechanisms Swing Pricing 329
Secondary Market 330
Exchange-Traded Funds 333
4.5.5 Investment Strategy Derivatives 335
Quantitative and Index Funds 338
Alternative Benchmark 338
4.5.6 Organizational Fund Structure Team-Managed Funds 339
Funds of Funds 339
Closed-End Funds 341
Pension Funds 342
4.6 Discussion 344
Part III Empirical Study 346
5 Objectives, Data and Methodology 346
5.1 Objectives 346
5.2 Data 351
5.3 Methodology 358
5.3.1 Ranked Portfolio Test 5.3.1.1 Formation 359
5.3.1.2 Evaluation 361
5.3.2 Regression Approach 364
6 Performance Persistence 366
6.1 Research Questions and Hypotheses 366
6.2 Performance and Characteristics of Decile Portfolios 368
6.2.1 Characteristics 368
6.2.2 Performance 373
6.2.3 Alternative Ranking Measures 381
6.3 Performance of Individual Decile Funds 388
6.3.1 Objective 388
6.3.2 Methodology 390
6.3.3 Bayesian Alphas 393
6.3.4 Alternative Estimation Methodologies 404
6.4 Alternative Formation and Evaluation Periods 410
Raw Returns 411
Risk-Adjusted Returns of Decile Portfolios 413
Risk-Adjusted Returns of Individual Decile Funds 416
Discussion 418
6.5 Migration 419
7 Fund Flows and Manager Changes as Equilibrium Mechanisms 428
7.1 Research Questions and Hypotheses 428
7.1.1 Winner Funds 429
7.1.2 Loser Funds 433
7.2 Methodology 435
7.2.1 Portfolio Formation 435
7.2.2 Specification of Multifactor Models 438
7.3 Winner Funds 441
7.3.1 Single sorting 441
7.3.2 Double sorting 453
7.4 Loser Funds 458
7.4.1 Single Sorting 458
7.4.2 Double Sorting 472
7.5 Winner-Minus-Loser Spread 478
7.6 Before-Fee Analysis 481
7.7 Regression Analysis 487
7.7.1 Model Specification 487
7.7.2 Results 489
7.8 Discussion 491
8 Time Effects, Extreme Flows and Capacity Constraints 495
8.1 Research Questions and Hypotheses 495
8.2 Alternative Formation and Evaluation Periods 499
8.2.1 Winner Funds 499
8.2.2 Loser Funds 503
8.3 Extreme Fund Flows and Fund Size 505
8.3.1 Portfolio Formation 505
8.3.2 Winner Funds 506
8.3.3 Loser Funds 512
8.4 Interaction of Fund Flows and Fund Size 516
8.4.1 Portfolio Formation 516
8.4.2 Winner Funds 517
8.4.3 Loser Funds 522
Conclusion and Outlook 526
Summary of the Results 526
Conclusions and Outlook 535
A Appendix 543
A.1 Factor-Mimicking Portfolios 543
A.2 Sample Selection 545
A.3 Alternative Estimation Methodologies 546
A.4 Alternative Formation and Evaluation Periods 547
A.4.1 Winner Funds 547
Absolute-Fund-Flows Sorting 547
Relative-Fund-Flows Sorting 549
A.4.2 Loser Funds 549
Absolute-Fund-Flows Sorting 549
Relative-Fund-Flows Sorting 551
A.5 Extreme Fund Flows and Fund Size 554
A.5.1 Winner Funds Absolute-Fund-Flows Sorting 554
Relative-Fund-Flows Sorting 556
Fund-Size Sorting 556
Factor Loadings 557
A.5.2 Loser Funds Absolute-Fund-Flows Sorting 559
Relative-Fund-Flows Sorting 561
Fund-Size Sorting 562
Factor Loadings 563
A.6 Interaction of Fund Flows and Fund Size 565
Bibliography 567