aswath_damodaran-investment_philosophies_2012

F I G U R E 1 3 . 7 Returns on Growth and Value Funds

Source: R. Bernstein, Style Investing (New York: John Wiley & Sons, 1995).

style. Thus, you often find value funds that buy growth stocks and growth funds investing in mature value companies.

Emerging Market and International Funds While active investing may not have much of a payoff in a mature market with wide access to information like the United States, intuitively you would expect the payoff to be much larger in emerging markets, where information is still not widely disseminated, or even in some European markets, where information tends to be tightly controlled by companies. You would therefore expect active mutual funds in these markets to do much better than they do in the United States, relative to passive indexes. Ahmed, Gangopadhyay, and Nanda examined 172 emerging market funds listed on Morningstar between 1980 to 2000 and computed the excess returns for these funds. Figure 13.8 summarizes their results.18

In each of the groupings, the actively managed funds underperformed the index. These results mirror those found in earlier studies of emerging market funds and suggest that active money management does not necessarily pay off in terms of excess returns, even in markets where money managers have information advantages. While this may seem surprising, transaction

18P. Ahmed, P. Gangopadhyay, and S. Nanda, “Performance of Emerging Market Mutual Funds and U.S. Monetary Policy” (SSRN Working Paper 289278, 2001).

F I G U R E 1 3 . 9 Jensen’s Alpha: Load versus No-Load Funds

Source: M. R. Morey, “Should You Carry the Load? A Comprehensive Analysis of Load and No-Load Mutual Fund Out-of-Sample Performance,” Journal of Banking & Finance 27 (2003): 1245–1271.

Younger funds seem to do much better than older funds in terms of both excess returns and delivering higher returns per unit of risk (Sharpe ratio). When funds are categorized by size, you find similar results, with smaller funds delivering marginally better performance than larger funds, though both lag the indexes. Indro, Jiang, Hu, and Lee examined the relationship between fund size and returns by categorizing funds into 10 size classes from largest to smallest.22 Though the funds that are in the bottom two deciles (the smallest funds) earn lower returns than other funds, largely because of higher costs, the economies of scale quickly decline and funds that exceed an optimal size (the top 10 percent of funds in terms of size) also have lower returns.

Fund manager characteristics. Does experience make fund managers better? Are older fund managers more likely to deliver high returns than younger fund managers? When funds are categorized based on the age

22D. C. Indro, C. X. Jiang, M. Y. Hu, and W. Y. Lee, “Mutual Fund Performance: Does Size Matter?” Financial Analysts Journal 55 (May/June 1999): 74–87.

F I G U R E 1 3 . 1 0 Excess Returns by Fund Age

Source: M. R. Morey, “Should You Carry the Load? A Comprehensive Analysis of Load and No-Load Mutual Fund Out-of-Sample Performance,” Journal of Banking & Finance 27 (2003): 1245–1271.

and experience of their managers, younger managers are more likely to generate positive excess returns than older managers. Younger managers are also more likely to exhibit herd behavior than older managers and to be fired after poor years (which may explain why they exhibit herd behavior in the first place).23 One study even looked for differences between male and female money managers and found no significant differences in returns.24

Retail versus institutional funds. There are some funds that cater exclusively to institutional and very wealthy individuals. They have minimum

23J. Chevalier and G. Ellison, “Are Some Mutual Fund Managers Better Than Others? Cross-Sectional Patterns in Behavior and Performance,” Journal of Finance 54 (1999): 875–899. They look at funds between 1988 and 1994 and correlate performance to age, SAT scores, and status of undergraduate institution. They find at the managers with higher SAT scores who went to more prestigious undergraduate institutions have slightly more positive returns than other managers.

24S. M. Atkinson, S. B. Baird, and M. B. Frye, “Do Female Mutual Fund Managers Manage Differently?” Journal of Financial Research 26 (2003): 1–8. They also find that net asset flows into funds managed by females are lower than for males, especially

for the manager’s initial year managing the fund.

0.50%

Excess Return (CAPM) Excess Return (4-factor model)

F I G U R E 1 3 . 1 1 Institutional versus Retail Funds: Annualized Excess Returns Source: C. James and J. Karceski, “Captured Money? Differences in the Performance Characteristics of Retail and Institutional Mutual Funds” (SSRN Working Paper 299730, 2002).

investment requirements of $100,000 or greater. Some of these funds are stand-alone offerings and some are offered by fund families that have retail mates. In Figure 13.11 we report the annual excess returns earned by these funds from 1995 to 1999 categorized by whether they cater to retail or institutional investors, and categorize the latter by minimum investment requirements—big if the minimum investment is greater than $500,000; small if the minimum is between $100,000 and $500,000—and by whether they are stand-alone or have retail mates.25 Note that the only funds that marginally beat the market are big institutional funds that have no retail mates.

Socially responsible funds. In the past decade, a large number of funds have been created to cater to investors who want to avoid companies that they deem socially irresponsible. Though the definition of social responsibility varies from fund to fund, the managers of these funds all argue that investing in ethical companies will generate higher returns in the long term. Arrayed against them are others who believe that

25C. James and J. Karceski, “Captured Money? Differences in the Performance Characteristics of Retail and Institutional Mutual Funds” (SSRN Working Paper 299730, 2002).

Source: J. Lakonishok, A. Shleifer, and R. Vishny, “Contrarian Investment, Extrapolation, and Risk,” Journal of Finance 49 (1994): 1541–1578.

constraining your investment choices will result in lower returns, not higher. In a finding that is bound to leave both groups dissatisfied, Bauer, Koedijk, and Otten examined 103 ethical funds in the United States, United Kingdom, and Germany from 1990 to 2001 and found no significant differences in excess returns between these funds and conventional funds.26

P e r f o r m a n c e C o n t i n u i t y When confronted with the evidence that the average actively managed fund underperforms the market, the reaction of some active money managers is that the average return is brought down by the laggards at the bottom. A profession, they argue, should be judged based on how those who are best do, rather than by the average. If they are correct, the best money managers should show both consistency and continuity in performance and earn much higher returns than the market.

Transition Likelihood Perhaps the simplest way to check for continuity is to rank money managers, based on performance, in one period and then look at the rankings in the next period. Lakonishok, Shleifer and Vishny, (referenced earlier) categorized pension fund money managers from 1983 to 1989 into quartiles based on performance each year, and looked at the likelihood of repeat performance. Their results are summarized in Table 13.3.

Note that you would have 25 percent in each box if performance rankings were completely random—a manager is the first quartile this year will have an equal chance of being in any of the four quartiles next year. The

26R. Bauer, K. Koedijk, and R. Otten, “International Evidence on Ethical Mutual Fund Performance and Investment Style,” Journal of Banking and Finance 29 (2005): 1751–1767.

actual percentages are not significantly different from 25%, with one exception. A manager who is in the lowest quartile this year has a higher chance of being in the highest quartile next year than in any other quartile. This should not be surprising, since this is exactly what you would expect from mutual funds that take considerable risk and make big bets on a few stocks. If the bets pay off, they move to the top of the rankings; and they do not, they drop to the bottom.

Standard & Poor’s provides updated versions of these transition matrices for mutual funds, allowing for liquidations and mergers. In its most recent assessment, S&P classifies active mutual funds in March 2008 into four quartiles, based on performance in the prior three years, and looks at the probabilities that they will remain in their respective quartiles based on returns over the next three years (April 2008 to March 2011) in Table 13.4.

As with the pension fund study, the degree of persistence is low, with the worst mutual funds in a three-year period actually being the most likely to transition to being the best ones in the subsequent three-year period. It is also worth noting that funds in the bottom two quartiles are far more likely to cease to exist in the next period.

Third Party Rankings and Ratings The rankings in Table 13.3 were based entirely on returns and can be faulted for not considering other qualitative factors. There are services like Morningstar that rate mutual funds, and rankings of mutual funds are also provided by the financial news media (the

Wall Street Journal, Forbes, and Bloomberg Businessweek, for example). These services also tend to have a powerful impact on the mutual fund business, with evidence that funds flow into those funds that have experienced a ratings upgrade from Morningstar and away from those funds that have experienced a ratings downgrade.27 But do funds that score high on these rankings repeat in future periods? More generally, are these rankings that

27D. Del Guercio and Paula A. Tkac, “Star Power: The Effect of Morningstar Ratings on Mutual Fund Flows” (SSRN Working Paper 286157, 2007).

Morningstar Rating Score

F I G U R E 1 3 . 1 2 Annualized Return Based on Morningstar Ratings, 1994 to 1997 Source: C. R. Blake and M. M. Morey, “Morningstar Ratings and Mutual Fund Performance,” Journal of Financial and Quantitative Analysis 35 (2000): 451–483.

are often used by investors as the basis for picking funds useful at predicting future performance?

Blake and Morey examine these questions, using the Morningstar ratings. Morningstar, which maintains one of the most comprehensive databases on mutual funds, assigns ratings ranging from one star (poor) to five stars (outstanding) to funds, based on both past returns and consistency.28 The influence of these ratings is illustrated by one study that found that 97 percent of the money flowed into funds with four or five star ratings.29 To test whether ratings provide any predictive power, Blake and Morey created a weighted score based on the 3-year, 5-year, and 10-year ratings (with 20 percent, 30 percent, and 50 percent weights respectively) for each fund and ranked the funds into 10 deciles based on the weighted score. They then computed the excess returns on funds in each decile between 1994 and 1997, and the results are summarized in Figure 13.12.

28C. R. Blake and M. M. Morey, “Morningstar Ratings and Mutual Fund Performance,” Journal of Financial and Quantitative Analysis 35 (2000): 451–483.

29This statistic was quoted in a Wall Street Journal article by Karen Damato titled

“Morningstar Edges Toward One-Year Ratings.” Wall Street Journal, April 5, 1996.