SPRING 2005
VOL. 6 NO. 2

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Investments in mutual funds now exceed the total value of bank deposits. Research from Smith’s finance department may give you some insight on what to look for when you invest in these vehicles.

PODCAST 

he mutual fund industry is growing extremely rapidly—there are now more mutual funds than stocks on the New York Stock Exchange. About 50 percent of adults invest in mutual funds, using them to save for retirement or their kids’ college educations. They have become so popular and so familiar to most Americans that many politicians believe individual investment plans like mutual funds should be incorporated into the nation’s Social Security system.

What makes these funds attractive to individual small investors is their combination of the advantages of a diversified portfolio and professional portfolio management with a minimum investment. But they have proved equally attractive to those with millions to invest.

For the 80 million Americans who invest in these vehicles, mutual fund performance is a subject of great interest. About three-fourths of all managed mutual funds underperform the stock market’s average return, according to investor-run Web site “The Motley Fool.” And many funds consistently underperform the market as a whole. So how can you maximize the return on your mutual fund investment? Advice on how to do so abounds, and it starts simple: avoid the losing funds. Bad choices are easy to spot—funds which overcharge and which didn’t do well last year qualify as losers. And since losing funds persist—that is, they continue to do poorly for a year or two after their first poor performance—it is worth the trouble to get rid of them.

Predicting winners, on the other hand, is the elusive Holy Grail of the finance industry, and Smith finance professors have been unraveling the many threads that affect the performance of mutual funds. Smith School Associate Professor of Finance Russ Wermers, who uses the best available statistical tools to measure mutual fund performance, says 90 to 95 percent of a fund’s performance is based on factors completely beyond the control of the fund manager. But the remaining five to ten percent depends on the skill of the fund manager, and that skill is what determines which funds will perform well and which won’t.

“Smart” Money
Wermers’ research indicates that mutual fund returns strongly persist—that is, funds that are performing well continue to perform well—over multi-year periods, and the behavior of consumers and fund managers both play a role in explaining these long-term continuation patterns.

Why does this happen? Consumers invest heavily in winning funds, wanting to capitalize on the success of the fund manager; winning funds generally receive a new cash inflow of 20 to 30 percent of existing assets under management the following year. Managers of winning funds invest this capital in stocks that did well the previous year, taking advantage of momentum—the phenomenon that dictates that stocks that did well last year will continue to do well the following year.

But momentum isn’t the only factor in the persistence of winning funds. Wermers also finds evidence that flow-related buying, especially among growth-oriented funds, pushes up stock prices. Stocks that winning funds purchase in response to persistent flows have returns that beat their size, book-to-market, and momentum benchmarks by two to three percent per year over a four-year period, well beyond the normal one-year momentum pattern found by past research.

What investment strategy does this suggest? Wermers doesn’t recommend that someone should invest based solely on momentum of a particular fund, but he notes that a fund that finished higher last year will do better than average this year.

“The return pattern lasts up to four years for growth-oriented funds,” he notes. “But, although fund net returns do tend to persist, they do not beat the S&P by much—thus, past-year return is an important decision variable but not the only one.”

Choose the Right Fund Manager
Choosing a successful fund manager is the next big variable to consider. Mutual funds roughly match the performance of the S&P 500, but good fund managers do manage to beat the market on average. So how do you recognize a good fund manager? Wermers’ research indicates that you might start by looking for a fund manager with a winning track record and lots of experience. Fund managers who actively manage their portfolios may consistently beat the results of passively managed index funds, but finding them can be tricky, since the outperformance is somewhat small for most. He notes that active management is more important with growth funds, as opposed to value funds.

Doron Avromov, assistant professor of finance at Smith, uses macro-economic variables to try to predict future stock returns. He finds that using information about the business cycle produces much better results; it improves performance very substantially, to the tune of 12 percent a year. Because there is strong predictability in mutual fund returns, Avromov recommends picking a fund manager who uses econometrics and models to evaluate the market.

Studying the portfolios held by fund managers gives you a more accurate view of their skill. Services like Morningstar provide information on fund performances, but unfortunately not at the level of detail that is most useful for evaluating fund managers.

Fund Governance
The third thing to consider is the governance of the fund. The Investment Company Act of 1940 mandated independent directors to act as shareholder watchdogs. Rampant trading scandals in recent years drove new SEC regulation intended to reduce mutual fund conflicts of interest. A new paper by Wermers and Bill Ding of SUNY-Albany recently presented at the Maryland Finance Symposium finds that funds with higher levels of board independence replace underperforming fund managers more readily. This evidence seems to be pointing to the fact that preserving and promoting board independence may be best for net returns, as independent directors find it easier to fire bad managers and thus (hopefully) revive losing funds.

So what’s the bottom line? When it comes to making the most of your mutual funds, what you don’t know can hurt you. Research shows that investors need access to more and better information to make the best choices—information that sometimes isn’t even available. “Portfolio holdings weren’t really studied before 1987,” says Wermers. “Only recently has the industry come under scrutiny from scholars and from consumers, who need more information about fund performance and the variables that are correlated with well-performing funds. That is why this research is important; it is driving the industry to make changes in this huge industry.”