Fund Performance

This note reviews the literature on fund performance. A practical way of gauging market efficiency is to attempt to identify above-average risk-adjusted returns from one or more market participants that are the result of skill, as opposed to luck. If any such returns are identified, then the market is not efficient. In practice, such a test is best performed by seeking persistence in the returns of fund managers; if persistence is identified, then markets are not efficient. From the articles reviewed, around 18 papers found evidence of manager skill/persistence in fund manager returns, whilst around 7 supported market efficiency. Of the five papers that explicitly mentioned market timing, none of them found that fund managers were able to time the market. It appears that stock picking is a worthwhile activity, whilst market timing is not. This bodes well for fundamental analysis, but poorly for technical analysis. UCL DEPARTMENT OF COMPUTER SCIENCE Fund Performance Martin Sewell A practical way of gauging market efficiency is to attempt to identify above-average risk-adjusted returns from one or more market participants that are the result of skill, as opposed to luck. If any such returns are identified, then the market is not efficient. In practice, such a test is best performed by seeking persistence in the returns of fund managers; if persistence is identified, then markets are not efficient. This note reviews the literature on fund performance in general, with a particular focus on performance persistence, and spans over 40 years of research. Sharpe (1966) looked at the performance of open-end mutual funds and found that to a major extent the capital market is highly efficient, but there is some evidence of persistence in performance. Jensen (1968) evaluated the performance of mutual funds in the period 1945–1964 and found no evidence of manager skill. Henriksson (1984) evaluated the performance of open-end mutual funds and concluded that their empirical results do not support the hypothesis that mutual fund managers are able to follow an investment strategy that successfully times the return on the market portfolio. Ippolito (1989) looked at mutual fund data and found evidence that is consistent with optimal trading in efficient markets. He concluded that risk-adjusted returns in the mutual fund industry, net of fees and expenses, are comparable to returns available in index funds. Grinblatt and Titman (1989) looked at mutual fund performance and tests indicated that the risk-adjusted gross returns of some funds were significantly positive. Sharpe (1992) described an asset class factor model, which makes it possible to determine how effectively individual fund managers have performed their functions and the extent (if any) to which value has been added through active management. Brown et al. (1992) showed that survivorship bias can give the false impression of persistence in mutual fund performance. Grinblatt and Titman (1992) looked at mutual fund data and found evidence that differences in performance between funds persist over time and that this persistence is consistent with the ability of fund managers to earn abnormal returns. Hendricks et al. (1993) found that in the period 1974–1988 relative performance of noload, growth-oriented mutual funds persisted in the near term, with the strongest evidence for a one-year evaluation horizon. Coggin et al. (1993) examined the investment performance of US equity pension fund managers. They found that pension fund managers were good at picking stocks, but poor at timing the market. The best managers produced substantial risk-adjusted excess returns. Brown and Goetzmann (1995) explored equity mutual fund data and found clear evidence of relative risk-adjusted performance persistence; however, the persistence was mostly due to funds that lag the S&P 500, depends upon the time period observed and is correlated across managers. Elton et al. (1995) found that bond funds underperformed the returns predicted by a relative pricing model that they developed by the amount of expenses, on average. They note that there is no evidence that managers, on average, can provide superior returns on the portfolios they manage, even if they provide their services free of cost. Grinblatt et al. (1995) found that mutual funds which bought past winners (followed a momentum strategy) realized significantly better performance than other funds. Brown et al. (1996) looked at growth-oriented mutual funds and demonstrated that mid-year losers tend to increase fund volatility in the latter part of an annual assessment period to a greater extent than mid-year winners. Elton et al. (1996a) provide estimates of survivorship bias that can be used as benchmarks to determine the amount of bias in studies that do not take survivorship bias into account. Elton et al. (1996b) found persistence in risk-adjusted stock mutual fund returns. Ferson and Schadt (1996) advocate conditional mutual fund performance evaluation in which the relevant expectations are conditioned on public information variables. This method made the average performance of the mutual funds in their sample look better. Gruber (1996) sought to solve the puzzle as to why investors buy actively managed open end mutual funds when their performance on average has been inferior to that of index funds. He suggests that the solution to the puzzle is that if managers have skill, future performance is in part predictable from past performance, and this management ability may not be included in the price. Ferson and Warther (1996) modified classical performance measures to take account of well-known market indicators (interest rates, dividend yields and other commonly available variables). This conditional performance evaluation makes mutual funds’ performance look better. Goetzmann and Peles (1997) presented evidence that cognitive dissonance explains mutual fund investor inertia. That is, investor aversion to switching from poor performers may be explained by overly optimistic perceptions of past mutual fund performance. Carhart (1997) considered the persistence in equity mutual funds’ mean and risk-adjusted returns. He concluded that the results do not support the existence of skilled or informed mutual fund portfolio managers. Daniel et al. (1997) looked at the performance of equity mutual funds. Their results showed that mutual funds, particularly aggressive-growth funds, exhibit some selectivity ability, but that funds exhibit no characteristic timing ability. Indro et al. (1999) reported that fund size (net assets under management) affects mutual fund performance and found that, in effect, 20% of nonindexed US equity funds were too small and 10% too large. Ackermann et al. (1999) examined hedge fund data from 1988–1995 and found that hedge funds consistently outperform mutual funds, but not standard market indices. However, hedge funds are more volatile than both mutual funds and market indices. Incentive fees explained some of the higher performance, but were not correlated with total risk. Chevalier and Ellison (1999) found that mutual fund managers who attended higher-SAT undergraduate institutions have systematically higher risk-adjusted excess returns. Liang (1999) looked at hedge fund performance.