Mutual Fund Performance and Manager Style. J.L. Davis, FAJ, Jan/Feb 01

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Mutual Fund Performance and Mutual Fund Performance and Manager Style. Manager Style. J.L. Davis, FAJ, Jan/Feb 01J.L. Davis, FAJ, Jan/Feb 01

Various studies examined the Various studies examined the evidence of persistence in mutual evidence of persistence in mutual fund performance. fund performance. General consensus is that a few General consensus is that a few fund managers do tend to fund managers do tend to consistently appear near the top of consistently appear near the top of the return rankings.the return rankings.

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Mutual Fund Performance Mutual Fund Performance and… and…

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

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

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Data and Methodology:Data and Methodology:DataDataUS Mutual Fund Database from US Mutual Fund Database from CRSP.CRSP.Time period: 1965-1998.Time period: 1965-1998.Data is free of Survivorship bias.Data is free of Survivorship bias. Explain the problem with survivorship Explain the problem with survivorship bias.bias.

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

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Sample consisted of 4,686 funds Sample consisted of 4,686 funds covering 26,564 fund-years from covering 26,564 fund-years from 1962-98, i.e.,in 26,564 time the fund 1962-98, i.e.,in 26,564 time the fund was classified as an equity fund and was classified as an equity fund and had at least one valid monthly had at least one valid monthly return.return.The median equity weight for the The median equity weight for the fund year: 93 percent.fund year: 93 percent.

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Style Identification:Style Identification: Fama-French Fama-French three factorthree factor model as model as presented below is used to infer fund’s presented below is used to infer fund’s investment style.investment style.RRitit–R–Rftft==ααii++ββii(R(Rm,tm,t–R–Rf,tf,t)+s)+si i SMBSMBtt+ + hhiiHMLHMLmm+e+ei,ti,tWhere,Where,RRitit= the percentage return to fund i,= the percentage return to fund i,RRftft = the U.S. T-bill rate = the U.S. T-bill rateRRmtmt = the return on the CRSP value weighted = the return on the CRSP value weighted index,index,SMBSMBtt = small cap return - large cap return, = small cap return - large cap return,HMLHMLtt = value return – growth return, = value return – growth return, eett = the error term. = the error term.

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Factor loading (sign of coefficients):Factor loading (sign of coefficients):1. 1. Small company stocks: positive sSmall company stocks: positive sii ; ;2. Large company stocks: negative s2. Large company stocks: negative sii ; ;3. Value factor: positive h3. Value factor: positive hii;;4. Growth factor: negative h4. Growth factor: negative hii ; ;5. Intercept (5. Intercept (αα) measures performance ) measures performance relative to three factor modelrelative to three factor model Funds were identified as Funds were identified as small cap or small cap or large caplarge cap on the basis of SMB slopes and on the basis of SMB slopes and as as value or growthvalue or growth on the basis of HML on the basis of HML slope.slope.

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

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

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

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GROWTH BLEND VALUE

SMALL

MEDIUM

LARGE

HML SORT

SMB SORT

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

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

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Results- Style Based PortfolioResults- Style Based PortfolioTable 1- Three Factor Results, HML Sorts.Table 1- Three Factor Results, HML Sorts.Panel A – Sorted by HML slopePanel A – Sorted by HML slopePanel B – Regression ResultsPanel B – Regression ResultsRR2 2 and t values indicate in favor of three and t values indicate in favor of three factor model.factor model.

- HML coefficient: growth- HML coefficient: growth+ HML coefficient: value+ HML coefficient: value

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Deciles 1-6: growth based on HMLDeciles 1-6: growth based on HMLDeciles 7-10: value based on HMLDeciles 7-10: value based on HMLDeciles 1-4 : positive Deciles 1-4 : positive Deciles 5-10: negative Deciles 5-10: negative Decile 10 : (Decile 10 : (=-.2) and significant, =-.2) and significant, i.e., underperformance i.e., underperformance

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Summary: Value fund did not Summary: Value fund did not performed better than growth fund. performed better than growth fund. Table 2 - Three Factor Results, SMB Table 2 - Three Factor Results, SMB Sorts.Sorts.

RR2 2 close to 1.close to 1.

negative and insignificant.negative and insignificant. Three factor model is appropriate Three factor model is appropriate

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Table 3- Independent HML and SMB Table 3- Independent HML and SMB sorts portfoliossorts portfoliosPanel A:Panel A:Low- Low corresponds to large-Low- Low corresponds to large-growth portfolio;growth portfolio;High-High corresponds to small-High-High corresponds to small-value portfoliovalue portfolio

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

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Table 4: Independent sorts on HML Table 4: Independent sorts on HML and and ..Panel A: Average for each portfolioPanel A: Average for each portfolioPanel B: Regression coefficientsPanel B: Regression coefficientsPanel C: Regression results one year Panel C: Regression results one year after formationafter formationPanel A: The spread in Panel A: The spread in value value between low and high between low and high portfolio is portfolio is about 1 percentage point.about 1 percentage point.

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

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

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Conclusion: Conclusion: 1.1. No investment style generated No investment style generated

abnormal returns over 1965-98.abnormal returns over 1965-98.2.2. Small evidence of persistence Small evidence of persistence

among best performing funds; among best performing funds; more evidence of performance more evidence of performance persistence among poor-persistence among poor-performing funds;performing funds;

3.3. Funds did not capture value Funds did not capture value premium. premium.

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Mutual Fund Performance and Manager Style. J.L. Davis, FAJ, Jan/Feb 01