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.
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
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
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.
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.”
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.
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.”