How funds with lower levels of competitive intensity can pay off
Mutual funds are an investment mainstay for many Americans, with more than 40 percent of U.S. households invested. But with over 9,500 mutual funds available in the United States, the options can be overwhelming.
With so many mutual fund companies and so many pricing options out there, how should an investor choose?
Maryland Smith’s Nagpurnanand R. Prabhala explored that question in recent research, with co-authors Nitin Kumar of the Indian School of Business and Gerard Hoberg of the University of Southern California. They created a new classification method for funds, and found that investors are better served finding a high-performing fund that faces lower levels of competitive intensity.
“Unsurprisingly,” says Prabhala, “the first factor that influences an investor’s decision is the fund’s past return, which is often used as a proxy for future returns.” This logic, he adds, goes against the disclaimers always posted by funds.
Investors and advisors do also consider whether the fund has consistently outperformed its stated benchmark, says Prabhala, professor of finance and area chair at the University of Maryland’s Robert H. Smith School of Business. But even that metric doesn’t necessarily work.
The researchers created a new classification that gives each fund its own set of competitor funds. The competitive intensity is the number of close rivals with a similar investing orientation. A fund could have just 25 rivals, for example, or as many as 150.
Prabhala says it is possible to more accurately measure a fund manager’s skill, by comparing the performance with the fund’s customized rivals. The researchers defined a metric, the customized peer alpha (CPA), which measures the performance of a fund relative to its close competitors.
And they asked two essential questions: Could the historic CPA of a fund predict future returns? And does competition affect the ability of high-CPA funds to generate high returns in future?
The answer to both, the research found, was yes. Past CPA predicts future fund performance. But it does so only for funds with fewer customized competitors.
“Our research thus helps investors by providing objective measures of historical performance and suggesting which outperforming funds might repeat in the future,” Prabhala says.
Read more: Mutual Fund Competition, Managerial Skill, and Alpha Persistence is published in The Review of Financial Studies.