Lu Zheng and Clemens Sialm
Unobserved Actions of Mutual Funds
Past returns and expenses aren't the only factors investors should take into account.
ANN ARBOR, Mich.—Mutual fund investors should consider more than a fund's past returns or expenses. They also should account for the unobserved actions of mutual fund managers, say researchers at the University of Michigan Stephen M. Ross School of Business.
"Despite extensive disclosure requirements, mutual fund investors do not observe all actions of fund managers," said Lu Zheng, assistant professor of finance at the Ross School. "They do not observe the exact timing of the purchases and the sales of securities and the corresponding transaction costs.
"On the one hand, fund investors bear hidden costs, such as trading costs, agency costs and negative investor externalities. On the other hand, they can benefit from unobserved interim trades by skilled fund managers who can use their informational advantage to time the purchases and the sales of the individual stocks optimally."
In a new study, Zheng and colleagues Clemens Sialm of the Ross School and Marcin Kacperczyk of the University of British Columbia estimate the impact of unobserved actions on mutual fund returns by using the return gap—the difference between the actual fund return and the buy-and-hold return of a portfolio that invests in the previously disclosed holdings.
By analyzing monthly return data on more than 2,500 U.S. equity funds from 1984 to 2003, the researchers found that the return gap helps to predict future fund performance—unobserved actions of some funds persistently create value, while such actions of others destroy value.
Funds with favorable past return gaps tend to perform consistently better before and after adjusting for differences in their risks and styles, they say. The top 10 percent of funds with the highest lagged return gap yields an average excess return of 1.2 percent per year relative to the market return, whereas the bottom 10 percent of funds with the lowest return gap yields an average excess return of -2.2 percent per year.
Trading costs, the researchers say, are an important component of the return gap—reducing returns to investors by as much as 0.6 percent per year.
Most funds in their sample, they say, exhibit a large correlation between holdings returns and investor returns, indicating little difference between a fund's actual investment and disclosed strategies (about a 1 percent difference). However, some funds have relatively low correlations between holding and investor returns, due to high portfolio turnover and the fairly common practice of "window-dressing."
"Since funds with low correlations are more opaque, unobserved actions are more important for these funds," said Sialm, assistant professor of finance at the Ross School. "Our results indicate that such opaque funds tend to exhibit particularly low return gaps, which suggest that these funds are subject to more agency problems, which induce them to camouflage their effective portfolio strategies."
The study also found that the return gap is positively related to the recent IPO (initial public offering) holdings of a fund and is related to other fund attributes, such as size, age and average new money growth.
"Mutual fund investors need to make investment decisions based on publicly available information," said Kacperczyk, assistant professor of finance at UBC. "It is well known that market participants cannot entirely observe several fund actions, which may benefit or hurt investors. Learning about them may help investors to evaluate funds more accurately."
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