Literature Review on Mutual Funds

A study was conducted by Grinblatt and Titman (1989) to examine the superior stock selection abilities of

mutual fund managers through which researcher generated abnormal returns. For this purpose a sample

of 274 funds was taken from 1974 to1984. Study applied Jensen Measure and compared the abnormal

returns of active and passive investment strategies both with and without transaction costs, fees, and

expenses. The results showed that the actual returns of these funds do not exhibit abnormal performance

indicating that investors cannot take advantage of the superior abilities of these portfolio managers by

purchasing shares in the mutual funds.

A company that collected money from a group of people with common investment objectives to buy

different securities is called mutual fund. The collected holding of these securities was known as its

portfolio Mark (2007). According to Teri (2007) mutual fund is a professional investment company which

managed collection of stocks, bonds, or other securities owned by a group of investor. Each mutual fund

had a fund manager who purchased and sold the fund’s investment according to the fund goals. Fund

managers were responsible to analyze the economic conditions, industry trends, government regulations

and the impact on stocks before selecting the securities for investment. 

Mutual funds provided investment facility to the small investors who cannot afford to invest the large sums

of money Teri (2007). Basically these small investors invested money into a common fund and handover

the investment decision to fund manager. Many people often regard the beginning of Foreign and

Colonial Government Trust as the beginning of modern day mutual funds. But the beginning of mutual

funds dates back to Seventeenth century when the first "pooling of money" for investments was done in

1774. Following the financial crisis of 1772-1773 a Dutch merchant Ketwich invited investors to come

together to form an investment trust under the name of Eendragt Maakt Magt David (2007). The purpose

of the trust was to provide diversification at low cost to the small investors. 

In order to spread risk, the fund invested in various countries such as Austria, Denmark, German States,

Spain, Sweden, Russia etc. In 18th century Amsterdam Stock Exchange had only a small number of listed

equities due to which the trust invested only in bonds. However after war with England many colonial

bonds defaulted due to which there was sharp decline in the investments. As a result, share redemption

was suspended in 1782 and later the interest payments were decreased too. The fund was no longer

attractive for investors and vanished. These early mutual funds before heading to the United States took

root in England and France in the 1890s. On the other hand “Massachusetts Investors' Trust of Boston”

was the first open-end fund Formed in 1924. The growth of pooled investments was hampered by stock

market crash of 1929 and the Great Depression but Securities Act of 1933 and Company Act of 1940

restored investor’s confidence and industry witnessed steady growth after that.

Several measures are used in the literature on mutual fund performance evaluation but there is (still) a

large controversy around them. Some of the important risk-adjusted techniques include the Sharpe (1966)

measure, the Treynor (1965) measure and the Jensen (1968) measure. These measures were frequently

called traditional measures of performance evaluation and were based on the idea that the combination of

any portfolio with the risk-free asset is located in the expected return or beta space. The Jensen measure

has been the most commonly used performance measure in academic and non-academic empirical

studies. On the other hand Sharpe’s reward-to-variability ratio was also very popular and was frequently

used by the researchers. Some of the empirical work on the performance of mutual funds was given

below. 

Sharpe (1966) introduced the measure to evaluate the mutual funds’ risk-adjusted performance. The

measure was 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 the capital

market was extremely 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 mutual funds were inferior investments during the period.

Previously two- and three-moment analyses were used to analyze the mutual fund performance relative

to market performance. But Joy and Porter (1974) applied first-, second-, and third-degree stochastic

dominance principles to investigate the same question. Study suggested that the proper test of mutual

fund performance relative to the market (DJIA) is a test employing stochastic dominance principles. Such

a test necessitates a pair wise comparison between each fund and the DJIA. Therefore Joy and Porter

(1974) collected the performance data for the 34 funds analyzed by both Sharpe (1966) and Arditti (1971)

for the ten-year period 1954-1963. Price and dividend data were also collected for the DJIA over the

same period. Study supported the earlier Sharpe (1966) study and opposed the Arditti (1971) work and

concluded that mutual fund performance was inferior to market performance over the period 1954-1963.