literature review of mutual funds 23.10.14
TRANSCRIPT
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
1/37
REVIEW OF LITERATURE
The published work relating to the topic is reviewed by the
Researcher. The relevant literature is reviewed on the basis of Books,
Periodicals, News Papers and Websites. The detailed review is given
below:-
Harry Markowitz (1952)1provides a theory about how investors
should select securities for their investment portfolio given beliefs about
future performance. He claims that rational investors consider higher
expected return as good and high variability of those returns as bad. From
this simple construct, he says that the decision rule should be to diversify
among all securities, securities which give the maximum expected
returns. His rule recommends the portfolio with the highest return is not
the one with the lowest variance of returns and that there is a rate at
which an investor can increase return by increasing variance. This is the
cornerstone of portfolio theory as we know it.
His portfolio theory shows that an investor has a choice of
combinations of return and variance depending on the percentage of
wealth invested in various combinations of risky assets. From this, he
1'Harry Markowitz "Portfolio Selection", Journal of Finance -, March 1952, Vo1.7, pp. 77-91
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
2/37
shows that a plot of all possible combinations of wealth divided among
possible combinations of securities will result in a circle. This circle will
be plotted on an xy grid with return plotted on one axis and risk, as
measured by variance on the other axis. The notion that investors desire
to maximize return for a given risk gives rise to some combinations of
securities dominating others in terms of risk and return characteristic.
These dominant portfolios are said to lie on the "efficient frontier".
If return is plotted on the vertical axis, variance on the horizontal
axis, and the circle of all possible combinations of risky assets is plotted
in return and variance space to obtain the efficient frontier, a point can be
plotted where the vertical distance represents the return on the risk-less
asset and the horizontal distance represents the risk (which is zero). A
straight line can be drawn from this point so that it touches the highest
point of the efficient frontier. This line is termed the "Capital Market
Line" (CML). If investors can both borrow and lend money at the risk
free rate of interest, they can select any level of return and variance they
are most satisfied with on that line. Any point on that line will provide a
higher return for the selected level of variance. The CML attracted a lot
of criticisms by the authors of Late 60's.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
3/37
The Wharton (1962)2study investigated mutual fund performance
in period t and the net inflow of money, or growth, in period t+1. The
study found only a weak positive relationship for common stock funds.
The methodology used was a two-by two contingency table that
compared the lower half of a particular sample in performance with the
lower half in growth, and conversely. This particular methodology has
been criticized. Smith (1978) called it "coarse" on the ground that it does
not use the data in the most efficient manner and is therefore not a strong
test of the performance-growth relationship.
`William Sharpe (1964)3and John Lintner (1965)
4separately extend
the work of Markowtiz. They show that the theory implies that the rates
of return from efficient combinations of risky assets move together
perfectly (will be perfectly correlated). This could result from their
common dependence on general economic activity. If this is so,
diversification among risky assets enables investors to escape from all
risks except the risk resulting from changes in economic activity.
Therefore, only the responsiveness of an asset return to changes in
2Wharton School of Finance and Commerce, A study of Mutual Funds, University Pennsylvania, U.S
Government Printing Office, 1962.
3Sharpe, "Capital Asset Prices - A Theory of Market Equilibrium Under conditions of Risk", Journal
of Finance, September 1964, pp 425-442.
4 John Linter, "Security Prices, Risk and Maximal Gains from Diversification", Journal of Finance,
December 1965, pp.5137.615.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
4/37
economic activity is relevant in assessing its risk. Investors only need to
be concerned with systematic risk [beta], not the total risk proposed by
Markowtiz. This gave birth to the "Security Market Line" (SML). The
difference between the Capital Market Line (CML) and SML is the
measure of risk used for the horizontal axis. The CML uses the variance
of returns, whereas the SML uses the systematic risk termed beta. Beta is
defined as the covariance between a security (or portfolio of securities)
and the market as a whole, divided by the variance of the market. The
market as a whole is considered the point of tangency between the SML
and the efficient frontier. This is the foundation for the Capital Asset
Pricing Model (CAPM).
Sharpe (1966)5in order to evaluate the risk-adjusted performance
of mutual funds introduced the measure known as reward to variability
ratio (Currently Sharpe Ratio). With the help of this ratio he evaluated the
return of 34 open-end mutual funds in the period 1945-1963. The results
showed that to a major extent the capital market was highly efficient due
to which majority of the sample had lower performance as compared to
the Dow Jones Index. Sharpe (1966) found that from 1954 to 1963 only
11 funds outperformed the Dow-Jones Industrial Average (DJIA) while
23 funds were outperformed by the DJIA. Study concluded that the
5Sharpe (1966), Mutual Fund Performance, The Journal of Business, 39, 1, 119-138.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
5/37
mutual funds were inferior investments during the period. Results also
showed that good managers concentrate on evaluating risk and providing
diversification.
Jensen (1968)6developed own measure known as Jensen's Alpha
to examine the risk- portfolios' risk-adjusted performance and estimate
the predictive ability of mutual fund managers. The measure was based
on the theory of the pricing of capital assets. For this purpose a sample of
115 open end mutual funds (for which net asset and dividend information
was available) was taken for the period 1955-1964. After applying the
Jensen measure he concluded that stock prices could not be forecasted
accurately with the help of mutual funds therefore buy and hold strategy
could not be used to take any advantage. Similarly there is slight evidence
that an individual mutual fund can achieve returns higher than a portfolio
comprised of randomly selected shares.
Carlson (1970)7 conducted a research to analyze the predictive
value of past results in forecasting future performance of mutual funds for
the period 1948-1667. The author also examined the efficiency of market
and identified the factors related to the fund performance. First of all he
6Jensen (1968), The Performance Of Mutual Funds In The Period 1945-1964, Journal of Finance, 23,
2, 1-36.
7Carlson (1970), Aggregate Performance of Mutual Funds, The Journal of Financial and Quantitative
Analysis, 5, 1, 1-32.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
6/37
constructed indices for three types of mutual funds (Diversified common
stock, Balanced, Income) and compared these indices with the market
indices. In order to analyze the performance regression was used. The
results provide empirical support to the return-risk postulate of the capital
asset pricing model and concluded that whether mutual funds outperform
the market depends on the selection of both the time period and market
proxy. The author also concluded that past performance showed little
predictive value and that the performance was positively related to the
availability of new cash resources for investment purposes.
Spitz (1970)8 related mutual growth to performance. Growth was
measured by net cash inflows which were defined as sales of capital
shares less the redemption of capital shares. A shortcoming of this growth
variable is that it includes investment returns (dividends and capital
gains) that are automatically reinvested. This procedure is incorrect
because additional shares purchased in this manner do not meet the
definition of new money because some of the shares purchased simply
compensate for payments; performance was measured by adding realized
and unrealized capital gains with gross income minus expenses (which
included management expenses). The data was on a yearly basis and
consisted of only 20 mutual funds over the time period from 1960 to
8Spitz, "Mutual Fund Performance and Cash inflows", Applied Economics, Vol.2, 1970, pp. 141-145.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
7/37
1967. Using time series correlations, Spitz tested two models. The first
was a contemporaneous model that related performance and growth in the
same period. The second model related growth in time period t with
performance in period t+1. The author concluded that the results were
generally insignificant.
Arditti (1971)9
criticized the reward-to-variability criterion
proposed by Sharpe (1966) on the grounds that it utilized only the first
two moments of the probability distribution of returns. Author proposed
that the third moment, a measure of the direction and size of the
distribution's tail, be included in the analysis. Arditti (1971) further
argued that investors preferred positive skewness because positive
skewness implied greater probability of higher return. Therefore assets
with relatively low reward-to-variability ratios would not be inferior
investments if ratios also have relatively high third moments (high
positive skewness). Furthermore author reexamined the Sharpe (1966)
data with this additional requirement and found that average fund
performance was not inferior to Dow Jones Industrial Average (DJIA)
performance because the skewness of the Dow Jones Industrial Average
(DJIA) return distribution was significantly less than fund skewness.
9 Arditti (1971), Another Look at Mutual Fund Performance, Journal of Financial and Quantitative
Analysis, 6, 909-912.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
8/37
Mcdonald (1973)10
developed a model to evaluate the investment
performance of funds holding securities in two countries. For this purpose
a sample of eight of the oldest French mutual funds was taken. The
monthly returns of these funds were calculated and analyzed for the
period 1964-1969. The results showed that the funds generally produced
superior risk-adjusted returns and that the French market was inefficient
with respect to the completeness and speed of dissemination of
information. The author concluded that those funds which invested in the
French market in 1964-69 generally achieved lower return at a given
level of variance than that reflected in the U.S. market returns.
Fama and McBeth (1973)11
examine the return of securities, using
OLS techniques and find that the CAPM, or market model, explains
returns well. They examined three testable implications of the market
model, (1) the relationship between risk and return is linear, (2) beta is a
complete measure of risk, and (3) higher risk should be associated with
higher returns. They conclude that none of the three testable implications
can be rejected. The results are consistent with efficient markets and a
sound asset pricing model, however, the estimated intercept was
somewhat higher than Rf.
10Mcdonald (1973) also found that the funds were generally able to attain superior returns relative to
naive portfolio strategy.
11Fama and McBeth, Risk Return and Equilibrium: Empirical Tests Journal of Political Economy,
May-June 1973, pp.607-636.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
9/37
McDonald (1974)12
conducted a research to examine the
objectives and performance (risk and return) of American mutual funds in
the period 1960-1669. Sample of 123 American mutual funds was
analyzed by using Treynor (1965) and Sharpe (1966) indexes. The results
indicated that stated objectives were significantly related to subsequent
measures of systematic risk and total variability. Therefore the funds with
aggressive objectives generally produced better performance. The results
also showed that 67 funds perform better than the stock market average in
case of Treynor's (1965) index while in case of Sharpe's (1966) index
only 39 mutual funds showed higher performance than the stock market
average. The author concluded that Average fund return increases with
increase in risk.
A study by Smith (1978)13
related mutual fund growth to fund
performance and found some positive relationships after adjusting for risk
using Jensen's Alpha. In carrying out the study, Smith tested two
hypotheses. The first was Mutual funds that improve their
performance in a given period, experience a growth rate in assets under
its management during the next period that is no different from that of
mutual funds that did not improve their performances...However, Smith
12McDonald (1973), Mutual Fund Performance: Evaluation of Internationally-Diversified Portfolios,
The Journal of Finance, 28, 5, 1161-1180.
13Smith, V., Is fund Growth Related to Fund Performance? The journal of Portfolio Management,
Spring 1978, pp 49-54.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
10/37
correctly recognized that the growth of a mutual fund's assets may be the
result of both new money flowing into the fund and to successful
investment performance. Smith accounted for this in his second
hypothesis by defining the growth in mutual funds in terms of
"outstanding shares" instead of "assets." However, using the growth in
outstanding shares incurs the same criticism as it did in Spitz's study, that
is, it incorrectly includes the reinvestment of dividends as new money.
Also, Smith used the "improvement" in investment performance as the
measurement variable affecting mutual fund money flows. The problem
with measuring the "improvement" in performance is that it ignores the
total, or overall, performance position of a fund relative to other funds.
To illustrate, the return, or investment performance of a fund may have
increased dramatically, but the fund may still have a total return that is
well behind other funds. A large amount of new money may not flow into
such a fund despite its recent performance improvement. Yet, Smith's
methodology examined exactly that aspect of the question.
To test his hypotheses Smith selected as performance variables the
non-risk adjusted performance measure developed by Jensen (1968)14
known as Jensen's Alpha which was estimated over the previous five-year
period. Growth periods of six and twelve months were examined
14 Jensen "The Performance of Mutual Funds in the Period 1945-1964", Journal of Finance, Vol.23.
May 1968, pp 389-416.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
11/37
subsequent to the performance estimates. The methodology consisted of
rank correlations relating the "change" in performance to the "change" in
growth in subsequent periods. The data used to test the first hypothesis
comprised of 74 common stock mutual funds for the time period 1964 to
1975. The second data set comprised 50 funds from 1960 to 1973. In his
analysis, Smith found no significant relationship when the Forbes rating
was related to either the growth in assets or the growth in shares. When
Jensen's Alpha was used as the explanatory variable, some significance
was found, but not enough to reject the null hypothesis. In addition to the
problems mentioned above, Smith himself noted that his study had two
basic shortcomings. The first was the small data base and the second was
that money flows may depend on variables other than the Forbes rating or
Jensen's Alpha.
Roll (1978)15
shows there is ambiguity when performance is
measured by the SML. The difficulty is that different market indices
provide different rankings. While previous work was mathematically,
theoretically, and intellectually rigorous, the author not only defined this
market portfolio but made an attempt to estimate a covariance matrix
with it. Theoretically, the market portfolio is the composition of all
investible assets. In practice, since this is not measurable, some proxy
15Roll "Ambiguity When Perfomncc is measured by the Securities Market Line", Journal of Finance,
Vol 33, September 1978, pp 1051-1069.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
12/37
must be used for the true market portfolio. The trouble is that even an
equally weighted and value weighted index of the same securities can
produce conflicting performance results when used as the proxy for the
market portfolio. The ambiguity of the SML arises because a different
beta can be generated for assets and portfolios by using different indices.
Therefore, beta is not an attribute of the individual asset. Beta is a
measure of the risk of an asset if included in a portfolio of risky assets
consisting of the market portfolio and a risk-less asset. Therefore,
differences in portfolio selection ability cannot be measured by the SML
criterion. If the index is ex-ante mean variance efficient, it is impossible
to discriminate between winners and losers. If the index is not ex-ante
mean-variance efficient, designating winners and losers is possible, but
another index can designate different winners and losers and there is no
way to determine which one is correct.
Therefore, Roll criticizes CAPM by saying that (1) the only valid
test is if the index is efficient, (2) if an index that is ex-post efficient is
chosen, every security will plot on a straight line, and (3) if the index is
inefficient etc-post, abnormal returns can be detected and ranking is
possible. Despite Roll's critique, research using CAPM continued. Since
both the Jensen and Treynor measure use a beta for the market portfolio,
they are both subject to this problem of determining the true market
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
13/37
portfolio and measuring its returns. This criticism is now far more
troubling. Many anomalies to CAPM have been documented since the
mid-1970's.
Basu (1977)16
shows that low price to earnings ratio portfolios
have greater risk adjusted returns than high P/E ratio portfolios. Banz
(1981)17
finds that returns on common stocks with low market equity
have greater risk adjusted returns than those stocks with high market
equity. However, the "size effect" is not a linear explanatory variable.
Copeland and Mayers (1982)18
show that a portfolio of stocks denoted
as "buy" by "Value Line" outperform a portfolio of "sell" stocks. Basu
(1983)19
shows that the P/E ratio effect that presented in 1977 also existed
after adjusting for the size effect reported by Banz (1981) Stickel
(1985)20
shows that changes in "Value Line" rankings are followed by
abnormal returns and this effect is greater for smaller firms. De Bondt
16Basu, "Investment Performance of Common Stocks in relation to Their Price Earnings Ratios: A Test
of the Efficient Market Hypothesis", Journal of Finance June 1977.
17Banz, "The Relationship between Market Value and Common Stocks" Journal of Financial
Economics, March 1981, pp.3- 18.
18Copeland and David, "The Value Line Engima (19641978): A Case Study of Performance
Evaluation Issues", Journal of Financial Economics, November 1982.
19Basu, "The Relationship between Earnings Yield, Market Value, and Return for NYSE Common
Stocks Further Evidence", Journal of Financial Economics, June 1983.
20
Stickel, "The Effect of Value Line investment Survey Rank Changes on Common Stock Prices",Journal of Financial Economics, Vol. 14, No.1, 1985.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
14/37
and Thaler (1985)21
test the "Overreaction Hypothesis" which claims
investors overreact to news and overweight recent information. They
conclude "loser" portfolio outperform "winner" portfolios by
approximately 25 per cent. Reinganum (1988)22
finds that price / book
ratios explain stock returns. Further, portfolios of stocks with price / book
ratios of less than one significantly outperform the S&P 500 index. Fama
and French (1988)23
show that dividend yields can forecast future
returns Lehmann (1990)24
finds that "winners" and "losers" one week
experience significant reversals the next week and that significant excess
returns can be generated by buying "losers". Jegadeesh (1990)25
examines the return on individual securities and provides evidence of
stock return predictability through a mean reversion process. Stocks that
perform exceptionally well in one year perform poorly in the next year,
whereas poorly performing stocks improve performance in the following
year. Lo and MacKinley (1990)26
also find contrarian trading rule
profits.
21De Bondt and Thaler, "Does the stock market over react?", Journal of Finance, Vol.40, 1985.
22Reinganum, The Anatomy of a Stock Market Winner", Financial Analysis Journal March - April,
1988.
23Fama and French, "Dividend Yields and Expected Stock Returns" Journal of Financial Economics,
October 1988.
24Lechman, "Fads, Martingales and Market efficiency" Quarterly Journal of Economics, February
1990.
25Jagadesh, "Evidence of Predictable Behavior of Security Returns", Journal of Finance, July 1990.
26
Lo and Craig, "When are Contrarian Profits due to Stock Market Overreaction?" Review of FinancialStudies, Vol.3, No.2, 1990.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
15/37
Miller and Nicholas (1980)27
conducted a research to examine the
risk-return relationships in the presence of non-stationarity in order to
obtain more precise estimates of alpha and beta. For this purpose this
study applied partition regression and a partition selection rule for
estimating the traditional CAPM in case of non-stationarity. Study
applied these procedures to price appreciation data for the market and 28
mutual funds for the period of 1973-1974. The results indicated a good
deal of non-cosistency in the risk-return relationships. The results showed
some weak positive relationships and some weak negative relationships
between betas and the rate of return for the market. On the other hand
results showed some weak positive relationships and some weak negative
relationships between betas and alphas. However, no general, statistically
significant relationships of either type were found.
In order to analyze the market-timing performance of mutual funds
a study was conducted by Henriksson (1984)28
. For this purpose a
sample of 116 open-end mutual funds from February 1968 to June1980
was taken. By using parametric and nonparametric techniques author
examined the performance of these open-end mutual funds using monthly
data. The returns data included all dividends paid by the fund and were
27Miller and Nicholas (1980), Nonstationarity and Evaluation of Mutual Fund Performance, The
Journal of Financial and Quantitative Analysis, 15, 3, 639 -654.
28Henriksson (1984), Market Timing and Mutual Fund Performance: An Empirical Investigation, The
Journal of Business, 57, 1, 73-96.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
16/37
net of all management costs and fees. Both the parametric and
nonparametric tests showed that mutual fund managers were unable to
follow a successful investment strategy. The results also showed that no
evidence was found that forecasters were more successful in the market-
timing activity with respect to predicting large changes in the value of the
market portfolio relative to smaller changes.
Woerheide (1982)29
used a somewhat different approach in
attempting to explain mutual fund money flows. The major objective of
his study was to identify the selection criteria investors seem to use in
buying and selling mutual fund shares once an investment objective had
been selected. Woerheide defined success as the selection by investors of
a given mutual fund, as measured by the net sales ratio. The net sales
ratio was defined as gross sales, less redemption, divided by total assets
at the start of the year. Woerheide's definition of success contains the
same error as the Spitz and Smith studies described above, that is, the
sales figures include reinvested dividends which should not be included
as new money. The selection criteria evaluated included two groups. The
first group was called "efficient market criteria," and the second group
"other factors." The rationale for the efficient market criteria was that
investors would prefer funds that were managed so as to maximize the
29Woerheide, "Investor Response to suggested Criteria for the Selection of Mutual Funds", Journal of
Finance and Quantitative Analysis, March 1982, pp 129-137.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
17/37
fund's return while minimizing its risk. The return-sensitive variables
were whether or not there was a load charge, the management expense
ratio, the portfolio turnover ratio, and the brokerage expense ratio. The
risk reducing variable was the number of different securities within the
mutual fund portfolio. This variable was selected on the basis that the risk
of a portfolio has been shown to decrease as the number of securities in it
increases. The "other" category of explanatory variables included items
that may influence an investor's selection of a particular mutual fund, but
were not directly related to the risk and return characteristics of the fund.
These variables included marketing strategy, mutual fund size, and prior
performance as measured by non-risk-adjusted rates of return.
To test his selection criteria, Woerheide confined his data to one
objective classification as defined by the 1977 edition of the "Investment
Companies" publication. The funds used in his study were classified as
"long-term growth, income secondary." The data used for each variable
tested depended on data availability, but covered the time period from
1972 to 1976 for 15 to 44 funds. The test intervals were one and three
year time periods. The methodologies varied according to the variables
being tested, but included correlation analysis, regression analysis, and a
comparison of means and standard deviations.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
18/37
Woerheide found no statistical significance for any of the efficient
market variables, and only weak statistical support for two of the "other"
variables, specifically, mutual fund size and prior return performance.
The marketing program variable was insignificant. Concerning the
direction of the relationship, Woerheide found that the absence of a load
charge was generally negatively related to his performance variable while
the management expense ratio had a positive sign. Woerheide concluded
that these relationships were incorrect. The turnover ratio, the brokerage
ratio, and the marketing program variables have a positive relationship.
These relationships were considered appropriate by Woerheide. The
variable representing the size of the mutual fund produce conflicting
results with respect to the direction of the relationship. Woerheide's
approach was sound in that he attempted to determine whether investors
use risk and return variables or "other" variables in selecting mutual
funds. But, his performance measures are not risk adjusted, and he
considered too few "other" explanatory variables. Overall, Woerheide's
conclusions must be questioned because the data base was small both in
terms of the number of funds and the time span.
In 198430
, Chang and Eric Chieh developed an investment
performance evaluation model in the multi-factor arbitrage pricing theory
30Chang, Eric, "Market timing and Mutual fund Investment Performance" Journal of Business January
1984, pp 57-72.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
19/37
framework and then empirically compared and applied; three investment
performance evaluation methodologies examined are the multi-factor
selectivity model, the single-factor selectivity model, and the single-
factor selectivity and timing model. Several criteria for comparison are
developed and the results are reported. The actual investment
performance of a sample of mutual funds is evaluated according to these
three methodologies. In general, they have provided evidences to show
that both the multi-factor selectivity model and the single-factor
selectivity and timing model are superior to the single-factor selectivity
model. However, the major conclusion about the non-superiority of
mutual funds investment performance drawn from the tests based on the
single-factor selectivity model have not been altered when more
sophisticated models are applied.
Ippolito (1989)31
conducted a research to analyze the efficiency in
capital markets when information is costly to obtain. Sample of 143
mutual funds were reported in the 1965 edition of Wiesenberger. The
analysis was done for the period of 19651984. Ippolito (1989) employed
CAPM model and made a comparison of results to those reported in
Jenson (1968). The results showed that Risk-adjusted returns in the
mutual fund industry, net of fees and expenses, were comparable to
31 Ippolito (1989) Efficiency with Costly Information: A Study of Mutual Fund Performance, 1965-
1984, The Quarterly Journal of Economics, 104, 1, 1-23.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
20/37
returns available in index funds. Results also indicated that portfolio
turnover and management fees were unrelated to fund performance. The
researcher concluded that mutual funds with higher turnover fees and
expenses, earn rates of return sufficiently high to offset the higher
charges. Research also concluded that the mutual funds were efficient in
the trading and information-gathering activities.
Jagadeesh and Narasimhan (1990)32
have developed a new
approach for testing asset pricing model . The principal advantage with
the approach is that it does not require specification of a particular form
for the alternate hypothesis. It allows use of individual for the alternate
hypothesis. It allows use of individual security data without aggregation
into portfolios which in general should increase the power of the tests. A
method for comparing the specifications of different asset pricing models,
which could be non-tested, is also proposed. This approach is used to test
the capital asset pricing model, a size based returns model and the
arbitrage pricing theory. In all these tests, the joint hypothesis of the
adequacy of the asset pricing model and market efficiency are rejected.
All of these tests indicate pronounced short term return reversal effect
which appears to be related to asset specific returns. Additional tests
further support such a conclusion.
32Jagadeesh, Narasimhan, "Evidence of Predictable Behavior of Security Returns", Journal of Finance,
July 1990.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
21/37
Santini, Donald Louis (1990)33
made an attempt to measure the
competitive success the mutual funds by assessing the ability to attract
new money. The main objective of this study is to identify those factors
that will explain the flow of new money into and out of common stock
mutual funds. This current research investigates the flow of new money
on three levels. The first level analyzes the flow of new money to the
entire mutual fund industry. The second level analyzes the flow of new
money after the mutual funds have been grouped according to their risk
and return characteristics. The third level analyzes the flow of new money
to individual mutual funds. The analysis is conducted on three levels
because the factors that are helpful in explaining the flow of funds on one
level may not be helpful on one, or both, of the other levels. The variables
included to explain the flow of new money are characterized as follows:
general environmental variables; risk objective classification variables;
and fund specific variables.
A research was conducted by Cumby and Jack (1990) 34 to
compare the performance of internationally diversified mutual funds with
international equity index and Morgan Stanley Index for the United
States. In this study a sample of fifteen U.S.-based internationally
33Donald Louis, "An Analysis of the Flow of New Money to Open-ended Mutual Funds", Dissertation
submitted in Boston University, Graduate School of Management, May 1990.
34Cumby and Jack (1990), Evaluating the Performance of International Mutual Funds. Journal of
Finance 45, 2, 497-521.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
22/37
diversified mutual funds between 1982 and 1988 was used. The
performance was then compared with the help of Jensen (1968) measure
and Positive Period Weighting Measure. The results concluded that the
performance of funds individually or as a whole was not higher than the
performance of international equity index. The authors also examined the
performance of the funds relative to the Morgan Stanley index for the
United States and found some evidence that the funds outperform the
U.S. index.
In 1992, Pinto and Jerald35
have incorporated three empirical
studies investigating the informational efficiency of the U.S. capital
markets. The evidence of each study is consistent with a traditional view
of market efficiency. The first paper examines forecasting ability and
performance of balanced mutual funds contemporaneously available to
investors, between 1965 and 1985, using quarterly asset composition
information in Wiesenberger Management Results. This first study to
apply asset information directly to mutual fund performance evaluation
finds that (1) asset allocation decisions exhibited insignificantly positive
success overall in forecasting the sign of the stock-bond relative return;
the distribution of successes over time did not exhibit clustering (contra
35Pinto and Jerald. E., Investment Management and Performance Evaluation (Portfolio Theory),
Unpublished Ph.D Thesis, Graduate school of Business Administration, New York University, 1992.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
23/37
Hendricks et al. (1988)36
); (2) macro forecasting performance was
natural for funds as a group; ability to forecast interest rates was
outweighed by inferior forecasting with respect to common stocks; (3)
the typical fund did not present the opportunity for a marginal mean-
variance improvement over a buy-and-hold investment in any of several
benchmark portfolios.
The second study relates the returns on 236 domestic equity mutual
funds over a period of 10 years between 1972 and 1982. To a return
generating equation incorporating the set of macroeconomic factors
developed by Burmeister and Wall (1986)37and Burmeister, Wall and
Hamilton (1986)38
. The focus is on the attribution of performance to
information about specific economic factors. This is of interest to
efficient markets theory as mutual fund managements expend substantial
resources in macroeconomic forecasting. Using transmitted effects
Mundlak (1978)39
regressions, we conclude that (1) adjustments in factor
exposure typically did not contain information about future factor values;
(2) the non-stock factors, in particular unanticipated inflation, are more
important than the market factor in explaining fund returns.
36Hendricks et.al. (1988) quoted Pinto and Jerald Thesis (Ph.D.) 1992.
37Burmeister and Wall (1986) Thesis (Ph.D.), 1992.
38
Wall and Hamilton (1986) Thesis (Ph.D.), 1992.
39Mundlak (1978) Thesis (Ph.D.), 1992.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
24/37
Grinblatt and Sheridan (1992)40
conducted a research to analyze
whether mutual fund performance relates to past performance. For this
purpose a sample of 279 funds was taken. Study divided the sample into
two five year sub periods and calculated the abnormal returns of each
fund for each five year sub period. Similarly the slope coefficient of
abnormal returns was computed in a cross-sectional regression. The
results indicated a positive persistence in mutual fund performance and
fund managers were able to earn abnormal returns. Therefore study
concluded that the past performance of a fund provides useful
information for investors who were considering an investment in mutual
funds.
Possibly the most compelling evidence is presented by Fama and
French (1992)41
. They find that book-to-market equity is the most
significant explanatory variable for predicting security returns, and that
portfolios with a low market-to-book value ratio have higher returns than
predicted by CAPM. They find that the combination of market-to-book
value and size explains returns and that beta is insignificant in a
regression that includes all three variables. This multi-beta approach is
40Grinblatt and Sheridan (1992), the Persistence of Mutual Fund Performance, The Journal of Finance,
47, 5, 1977-1984.
41Fama and French, "The cross-section of Expected stock returns", Journal of Finance, June,1992.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
25/37
somewhat related to the work or Ross (1976)42
who developed the
Arbitrage Pricing Theory (APT). They use the statistical procedure of
factor analysis to determine the relationship between factors thought to
effect security returns and actual returns APT is a rival CAPM and its
treatment is beyond the scope of this study. However, there is increasing
support for theories other than a single factor CAPM. The issue of
whether non-fundamental factors such as investor fads or sentiment affect
stock prices has long been a contentious issue in financial economics.
Recently, it has been proposed that the closed-end fund discount puzzle
and the small firm effect may be related to the actions of individual
investors who trade based on sentiment. Empirical studies that show that
movements in closed-end fund discounts and small firm prices are
correlated have been interpreted as evidence that investor sentiment
affects stock prices.
A research was conducted by Martin et al. (1993)43
to examine the
performance of bond mutual funds. Samples of bond fund: first sample
was designed to eliminate survivorship bias and was comprised of the 46
non-municipal bond funds for the 10-year period from the beginning of
42 Rass, "The Arbitrage Theory of Capital Asset Pricing'', Journal of Economic Theory, December,
1976.
43Martin et al. (1993), 'Efficiency with costly information: A reinterpretation of evidence from
managed portfolios', Review of Financial Studies, 6, 1, 1-22.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
26/37
1979 to the end of 1988. The second sample consisted of all bond funds
that existed at the end of 1991. Researcher used linear and nonlinear
models in order to examine the two samples. The results showed that
bond funds underperform relevant indexes post expenses.
Swaminathan and Bhaskaran (1994)44
made on attempt to focus
on the implications of individual investor behavior for the pricing of
close-ended funds and small firms. Specifically, they developed a two
security, noisy rational expectations model of closed-end funds and
compare its predictions to that of a model of investor sentiment. The
rational model shows that the estimation errors of rational but imperfectly
informed small, individual investors can give rise to average discounts.
However, discounts cannot track time variation in expected returns
induced by mean reversion in small investor estimation errors. In
contrast, in a model of investor sentiment, discounts can track time
variation in expected returns induced by mean reversion is small investor
sentiment. This implies that discounts can forecast stock returns either if
they are a proxy of investor sentiment or if they are a proxy of some
fundamental factor.
44
Swaminathan and Bhaskaran, "The Implications of Individual Investor Behavior for the Pricing ofClose-Ended Funds and Small firms", Unpublished Ph.D Thesis, submitted to University of California,
1974.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
27/37
Their empirical tests examine the time series implications of the
two models. The results indicate that discounts forecast small firm
returns. They also show that the forecasting power of discounts is not
related to that of any known fundamental forecasting variable. This
evidence provides support for the investor sentiment explanation of the
pricing of closed-end funds and small firms, and suggests that there may
be sentiment related variation in small firm expected returns.
Malkiel (1995)45
conducted a research to analyze the performance
of equity mutual funds for the period 1971 to 1991. For this purpose
study involved a data set that included the returns from all mutual funds
in existence in each year of the period. After analyzing the returns from
all funds he found that mutual funds underperformed the market.
Survivorship bias was considered to be the important part of the analysis.
Study also examined the fund returns in the context of the capital asset
pricing framework and neither found any evidence of excess return nor
observed any risk return relationship stated by the capital asset pricing
model. Study concluded that it was better for the investors to purchase a
low expense index fund than to select an active fund manager.
45Malkiel (1995), 'Returns from investing in equity mutual funds 1971 to 1991', Journal of Finance, 50,
2, 549-572.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
28/37
The study by Lee,Sunghoon in (1995)46
makes three contributions
to the literature on the evaluation of mutual fund performance. First, it
evaluates various empirical models of the bond return generating process
and suggests new benchmarks that are the most appropriate for evaluating
the performance of managed bond portfolios. Second, it provides
thorough empirical evidence concerning the performance of bond mutual
funds and examines the sensitivity of performance inferences to
benchmark choice. Third, it analyzes the cross-sectional and inter-
temporal behavior of performance measures to determine the relationship
between performance and various fund characteristics. The
appropriateness of benchmarks is tested in both the specialized context of
mean-variance efficiency and in the more general context of goodness-of-
fit comparison. Among the six proposed benchmarks, the two-factor
model, consisting of the composite bond index and six-month Treasury
bill index, and the three-factor model, consisting of the composite bond
index, are the most appropriate for performance evaluation of bond
mutual funds. They find little evidence that the managers of bond fund as
a class provide superior performance after accounting for expenses
relative to various benchmark returns. While the average Jensen alphas
across benchmarks are predominantly negative in both the full sample
period and in the first sub-period, bond mutual funds exhibit better
46Lee, Sunghon, "The evaluation of Bond Mutual Fund Performance", Unpublished Ph.D, Thesis
submitted to State University of New york, Buffalo, 1995.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
29/37
performance with a considerable decrease in the number of funds with
significantly negative Jensen alphas during the second sub-period
spanning from 1984 to 1989.
Another study by Prather and Larry Joseph (1995)47
reexamines
performance evaluation of managed portfolios. Past measures of portfolio
evaluation such as the Sharpe, Treynor, and Jensen measures are subject
either to the inability to rank performance based on statistical
significance, or are dependent on both a single factor CAPM return
generating process and the selected market portfolio. Recent studies show
performance ranking is sensitive to the selection of the market proxy
when the security market line is used to evaluate performance.
Additionally, CAPM based measures that appeared to work well in the
1960's no longer appear to function effectively. Many anomalies to
CAPM have been documented since the 1970's and recently, Fama and
French (1992)48
declared the CAPM beta to be dead.
47Prather, Larry Joseph, "New Paradigms for Evaluating Performance and Performance Persistency of
Domestic and Globally Diversified Portfolios", Unpublished Ph.D Thesis submitted in Old Dominion
University.
48
Fama and French, "The Cross-section of Expected Stock Returns", Journal of Finance, December1984.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
30/37
Cai et al. (1996)49
evaluated the performance of Japanese open
type equity funds from 1981 to 1992. For this purpose a sample of 800
open-type mutual funds run by 9 management companies was taken. Two
benchmarks (value-weighted single-index benchmark and three-factor
benchmark) were used in the analysis. This research used Jensen
Measure, Positive Period Weighting (PPW) Measure and Conditional
Jensen Measure in order to evaluate the performance of these funds. The
results showed that value-weighted and equal-weighted portfolios of 800
mutual funds underperform the single-index benchmark by approximately
7.0% and 6.0%. The results also showed that most of the funds were
inclined to invest more in large stocks.
Otten and Dennis (1999)50
analyzed the performance of European
mutual funds from 1991 through December 1998. Study also investigated
the performance of fund managers along with the influence of fund
characteristics on risk-adjusted performance. For this purpose a sample of
506 funds was taken and 4-factor model was used. The results indicated
that the European mutual funds especially small cap funds were able to
add value and 4 out of 5 countries exhibit significant outperformance at
an aggregate level. The results also revealed positive relation between
49Cai et al. (1997), The performance of Japanese mutual funds, The Review of Financial Studies, 10, 2,
237-273.
50Otten and Dennis (1999), European mutual fund performance, European Financial Management, 8,
1, 75-101.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
31/37
risk-adjusted return and fund size and negative relation between risk-
adjusted and funds' expense ratio.
Zheng, Lu, (1999)51
Yale university Contributed three essays on
Investment cash flows regarding mutual funds, Stock prices. These essays
study cash flow related behavior of different classes of investors and
examine possible market impact of these investment cash-flows. The first
essay looks into open-end equity mutual fund shareholders' fund selection
ability by analyzing the performance predictability of investors' cash-
flows. Using a large sample of equity funds, the researcher could notice
that funds that receive more money subsequently perform significantly
better than those that lose money. This effect is short-lived and is largely
but not completely explained by a strategy of betting on winners. In the
aggregate, there is only marginal evidence that funds that receive more
money subsequently beat the market. However, it is possible to earn
significant positive abnormal returns by using the cash-flows information
for small funds. The second essay examines the relation between stock
prices and cash-flows from different investment sectors. Using long-term
data on stock market and investment cash-flows, it was identified that
there are some investment sectors which can effectively set stock prices.
These sectors include mutual funds, foreign investors, and pension funds.
51 L.U. Zheng, "Investment Cash Flows Regarding Mutual Funds, Stock Prices" Unpublished Ph.D
Thesis submitted in Yale University, 1999.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
32/37
Further, the study examined the economic significance of the possible
market impact of these sector cash-flows by studying the
contemporaneous relation between stock market returns and the sector
cash-flows. The researcher found no Granger-causality between quarterly
stock market returns and the sector cash-flows in either direction. By
studying the response of the sector cash-flows to shocks in stock returns
over time, the researcher observed a much longer memory for the mutual
fund sector than for any other sectors in the economy. The third essay
examines the relation between stock market volatility and cash-flows
from different investment sectors. It is observed that cash inflows of
close-end funds are positively related to contemporaneous upward
volatility, and that cash outflows of foreign investors and mutual funds
are positively related to both upward and downward volatility. The VAR
analysis indicates that unexpected cash outflows of foreign investors and
mutual funds are positively correlated with contemporaneous downward
volatility of the stock market. In the long run, household investors pursue
a volatile upward market while mutual funds and other institutional
investors are averse to high volatility in a downward market.
Redman (2000)52
analyzed the risk adjusted returns for five
portfolios of international mutual funds. The study was conducted for
52Redman (2000) the Performance of Global and International Mutual Funds, Journal of Financial and
Strategic Decisions 13, 1, 75-85.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
33/37
three periods: 1985-1994, 1985-1989, and 1990-1994. The performance
was measured by using Treynor (1965) Index Sharpe (1966)'s Index and
Jensen's Alpha and comparison was made with the U. S. market. Results
showed that under Sharpe (1966)'s and Treynor (1965) indices the
performance of portfolios of international mutual funds was higher than
the U. S. market from 1985-1994 and 1985-1989. On the other hand
performance of U.S equity portfolio and the market index was higher
than global portfolios from 1990-1994.
Stehle and Olaf (2001)53
conducted a research to evaluate the
open-ended mutual funds risk-adjusted performance. Study used a data
set that included all German funds sold to the public in 1972. The
research analyzed covers the time period of 1973 to 1998. DAX, which
included the 30 largest German stocks and DAX100, which included the
100 largest German stocks were used as benchmarks for comparison.
First of all researchers examined the rates of return of individual funds
with the help of Sharpe (1966) and Jensen measures and then applied the
same measures to evaluate the unweighted average rates of return of all
funds. In case of the rates of return of individual funds, results showed
that the funds underperform the appropriate benchmarks by
approximately 1.5 % per year. On the other hand underperformance was
53Stehle and Olaf (2001), The Long-Run Performance of German Stock Mutual Funds, Working
Paper, Humboldt-Universitat zu Berlin.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
34/37
reduced by 40 % in case of unweighted average rates of return. Study also
concluded that the large German stock mutual funds, on the average,
performed better than the small ones.
A study was conducted by Otten, and Mark (2002)54
to compare
the performance of European mutual fund industry with performance of
United States fund industry. Sample of 506 European open-ended mutual
funds and 2096 American open-ended mutual funds was taken from
January 1991 to December 19979. Study was restricted the sample to
purely domestic equity funds with at least 24 months of data. Results also
indicated that European mutual funds had on average a better
performance than the American counterparts and that the small cap
mutual funds in both Europe and the United States outperformed the
benchmark and all other mutual funds.
Noulas, John and John (2005)55
evaluated the risk adjusted
performance of Greek equity funds during the period 1997-2000. This
study is based on weekly data for equity mutual funds and includes 23
equity funds that existed for the whole period under consideration.
Mutual funds were ranked on the techniques used by Treynor (1965),
54Otten, and Mark (2002), A Comparison between the European and the U.S. Mutual Fund Industry,
Managerial Finance, 28, 1, 1434.
55Noulas, John and John (2005), Performance of Mutual Funds. Managerial Finance, 31, 2, 101-112.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
35/37
Sharpe (1966) and Jensen. Results showed positive returns of the stock
market for the first three years and negative returns for the fourth year.
The results also indicated that the beta of all funds is smaller than 1 for
four-year period. The authors concluded that the equity funds have
neither the same risk nor the same return. The investor needs to know the
long-term behavior of mutual funds in order to make the right investment
decision.
Leite and Cortez (2009)56
conducted a research to analyze the
impact of using conditioning information in evaluating the performance
of mutual funds. For this purpose two different samples of Portuguese-
owned open end equity funds were built, over the period of June 2000 to
June 2004. The first sample contained surviving 24 funds (10 National
funds and 14 European Union funds) at the end of June 2004. While the
second sample included all surviving and 20 non-surviving funds during
the sample period. Both conditional and unconditional models were used
to evaluate the performance. The results of unconditional model indicated
that the performance of National funds was neutral while the performance
of European Union funds was negative. On the other hand conditional
models suggested that conditional betas (but not alphas) are time-varying
and dependent on the dividend yield variable.
56Leite and Cortez (2009), "Conditional Performance Evaluation: Evidence from the Portuguese
Mutual Fund Market", Working Paper, University of Minho.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
36/37
Boudreaux and Suzanne (2010)57
conducted a study to examine
the risk adjusted returns of international mutual funds for the period of
2000-2006. For this purpose a sample of ten portfolios of international
mutual fund was taken and risk-adjusted performance was calculated by
using Sharpe (1966)'s Index of Reward to Variability ratio. US market of
mutual funds was taken as the benchmark. The results showed that the
performance of nine out of ten of the international mutual fund was
higher than the U.S. market. Those portfolios which contained only U.S
stock mutual funds underperform on a risk adjusted the funds that
contained all international mutual funds. The authors concluded that
Investors may not fully take advantage of possible portfolio risk
reduction and higher returns if international mutual funds were excluded.
Arugaslan and Ajay (2012)58
examined the risk-adjusted
performance of US-based international equity funds from 19942003. The
analysis was done for five-year period 1999-2003 and ten-year period
1994-2003. For this a sample of 50 large US-based international equity
funds was taken and a new method of measurement Modigliani and
Modigliani (M squared) was applied. The performance was compared
with both domestic and international benchmark indices. The results
57Boudreaux and Suzanne (2010), Empirical Analysis of International Mutual Fund Performance,
International Business & Economics Research Journal, 6, 19-22
58 Arugaslan, and Ajay (2012), Evaluating large US-based equity mutual funds using risk-adjusted
performance measures, International Journal of Commerce and Management, 17, 1/2, 624.
-
8/10/2019 Literature Review of Mutual Funds 23.10.14
37/37
showed that the risk has great impact on the attractiveness of Funds.
Higher return funds may lose attractiveness due to higher risk while the
lower return funds may be attractive to investors due to the lower risk.
Dietze, Oliver and Macro (2013)59
conducted a research to
evaluate the risk-adjusted performance of European investment grade
corporate bond mutual funds. Sample of 19 investment-grade corporate
bond funds was used for the period of 5 years (July 2000 - June 2005).
Funds were evaluated on the basis of single-index model and several
multi-index and asset-class-factor models. Both maturity-based indices
and rating based indices were used to account for the risk and return
characteristics of investment grade corporate bond funds. The results
indicated that the corporate bond funds, on average, underperformed the
benchmark portfolios and there was not a single fund exhibiting a
significant positive performance. Results also indicated that the risk-
adjusted performance of larger and older funds, and funds charging lower
fees was higher.
59