1 Mutual Fund Performance and Manager Style. J.L. Davis, FAJ, Jan/Feb 01 Various studies examined the evidence of persistence in mutual fund performance. Various studies examined the evidence of persistence in mutual fund performance. General consensus is that a few fund managers do tend to consistently appear near the top of the return rankings. General consensus is that a few fund managers do tend to consistently appear near the top of the return rankings.

2 Mutual Fund Performance and… Strong evidence that some fund managers consistently appear near the bottom of the ranking. Strong evidence that some fund managers consistently appear near the bottom of the ranking. The implication for investors: Small likelihood of consistently earning abnormal returns by seeking individual fund managers. The implication for investors: Small likelihood of consistently earning abnormal returns by seeking individual fund managers.

3 Mutual Fund Performance and… Objective of this Study: Examine the relationship between equity fund performance and manager style. 1. Examine whether any investment style reliably delivers abnormal performance; 2. Evidence of performance per- sistence based on style.

4 Mutual Fund Performance and… Data and Methodology: Data US Mutual Fund Database from CRSP. Time period: Data is free of Survivorship bias. Explain the problem with survivorship bias. Explain the problem with survivorship bias.

5 Mutual Fund Performance and… Selection Criteria for funds to be included in the data set: 1. If a fund’s stated objective was growth, growth and income, maximum capital gains, small-cap growth, or aggressive growth; 2. Objective not listed but policy statement indicated that they primarily invested in common stocks.

6 Mutual Fund Performance and… Sample consisted of 4,686 funds covering 26,564 fund-years from , i.e.,in 26,564 time the fund was classified as an equity fund and had at least one valid monthly return. Sample consisted of 4,686 funds covering 26,564 fund-years from , i.e.,in 26,564 time the fund was classified as an equity fund and had at least one valid monthly return. The median equity weight for the fund year: 93 percent. The median equity weight for the fund year: 93 percent.

7 Mutual Fund Performance and… Style Identification: Fama-French three factor model as presented below is used to infer fund’s investment style. Fama-French three factor model as presented below is used to infer fund’s investment style. R it –R ft =α i +β i (R m,t –R f,t )+s i SMB t + h i HML m +e i,t R it –R ft =α i +β i (R m,t –R f,t )+s i SMB t + h i HML m +e i,tWhere, R it = the percentage return to fund i, R ft = the U.S. T-bill rate R mt = the return on the CRSP value weighted index, SMB t = small cap return - large cap return, HML t = value return – growth return, e t = the error term.

8 Mutual Fund Performance and… Factor loading (sign of coefficients): 1. Small company stocks: positive s i ; 2. Large company stocks: negative s i ; 3. Value factor: positive h i ; 4. Growth factor: negative h i ; 5. Intercept (α) measures performance relative to three factor model Funds were identified as small cap or large cap on the basis of SMB slopes and as value or growth on the basis of HML slope. Funds were identified as small cap or large cap on the basis of SMB slopes and as value or growth on the basis of HML slope.

9 Mutual Fund Performance and… Portfolio Formation: Funds were placed in style portfolios at the beginning of each year from Portfolio Formation: Funds were placed in style portfolios at the beginning of each year from Returns for the previous 36 months were used to estimate performation slopes on the HML and SMB factors. Returns for the previous 36 months were used to estimate performation slopes on the HML and SMB factors. Based on the slopes, funds were allocated into portfolios, and returns were calculated for each month of Based on the slopes, funds were allocated into portfolios, and returns were calculated for each month of 1965.

10 Mutual Fund Performance and… The process was repeated for each year. The process was repeated for each year. Univariate SMB and HML sorts to form decile portfolios and bivariate sorts to form portfolios based on intersection of the HML and SMB ranking. Univariate SMB and HML sorts to form decile portfolios and bivariate sorts to form portfolios based on intersection of the HML and SMB ranking.

11 Mutual Fund Performance and… Funds were divided into thirds (low, medium and high) on the basis of SMB and HML rankings. Funds were divided into thirds (low, medium and high) on the basis of SMB and HML rankings. This 3x3 partition produced nine portfolios - high SMB/Low HML (small/growth) portfolio. This 3x3 partition produced nine portfolios - high SMB/Low HML (small/growth) portfolio. Repeating this process for each year yielded a time series of 408 equally weighted monthly returns for each portfolio Repeating this process for each year yielded a time series of 408 equally weighted monthly returns for each portfolio

12 Mutual Fund Performance and… GROWTHBLENDVALUE SMALL MEDIUM LARGE HML SORT SMB SORT

13 Mutual Fund Performance and… Test of performance persistence used bivariate sorts on HML and  and SMB and . Test of performance persistence used bivariate sorts on HML and  and SMB and . For example, (Low HML/Low  ) implies growth emphasis and performed poorly compared with the three-factor benchmark. For example, (Low HML/Low  ) implies growth emphasis and performed poorly compared with the three-factor benchmark.

14 Mutual Fund Performance and… Tests of Abnormal Returns: 1. Davis, Fama and French - three factor model (excess market returns, the size and value- growth factors) have explanatory power; 2. If premiums associated with size and value can be earned by passive strategy by buying diversified portfolios with desired level of risk, therefore, an active manager should be able to outperform such passive strategy. 2. If premiums associated with size and value can be earned by passive strategy by buying diversified portfolios with desired level of risk, therefore, an active manager should be able to outperform such passive strategy.

15 Mutual Fund Performance and… Results- Style Based Portfolio Table 1- Three Factor Results, HML Sorts. Panel A – Sorted by HML slope Panel B – Regression Results R 2 and t values indicate in favor of three factor model. - HML coefficient: growth + HML coefficient: value

16 Mutual Fund Performance and… Deciles 1-6: growth based on HML Deciles 7-10: value based on HML Deciles 1-4 : positive  Deciles 5-10: negative  Decile 10 : (  =-.2) and significant, i.e., underperformance

17 Mutual Fund Performance and… Summary: Value fund did not performed better than growth fund. Table 2 - Three Factor Results, SMB Sorts. R 2 close to 1.  negative and insignificant. Three factor model is appropriate Three factor model is appropriate

18 Mutual Fund Performance and… Table 3- Independent HML and SMB sorts portfolios Panel A: Low- Low corresponds to large-growth portfolio; High-High corresponds to small-value portfolio

19 Mutual Fund Performance and… No style portfolio show reliable abnormal profit, a tendency for value funds to under perform growth fund is clear when SMB sensitivity is held constant. No style portfolio show reliable abnormal profit, a tendency for value funds to under perform growth fund is clear when SMB sensitivity is held constant. Conclusion from Tables 1-3: Value funds performed poorly over the past 30 year period. Conclusion from Tables 1-3: Value funds performed poorly over the past 30 year period.

20 Mutual Fund Performance and… Table 4: Independent sorts on HML and . Panel A: Average for each portfolio Panel B: Regression coefficients Panel C: Regression results one year after formation Panel A: The spread in  value between low and high  portfolio is about 1 percentage point.

21 Mutual Fund Performance and… Panel B: For high HML portfolio, all three  values are negative, i.e, value funds have not done well. Panel B: For high HML portfolio, all three  values are negative, i.e, value funds have not done well. Low HML/high  has a +.14  value, i.e., some growth mangers have been able to maintain good performance over short period. Advantage disappears in Panel C. Low HML/high  has a +.14  value, i.e., some growth mangers have been able to maintain good performance over short period. Advantage disappears in Panel C.

22 Mutual Fund Performance and… Table 5: Independent sorts on SMB and . Panel A: The spread in  value between low and high  portfolio is about 150 bps. Panel B: The spread falls to 25 bps. Panel C: Spread is less than 10 bps. Conclusion: Some evidence of persistence, but dies quickly.

23 Mutual Fund Performance and… Conclusion: 1. No investment style generated abnormal returns over Small evidence of persistence among best performing funds; more evidence of performance persistence among poor-performing funds; 3. Funds did not capture value premium.