Journal of Financial Planning: November 2015
David Nanigian, Ph.D., is an associate professor of investments in the Richard D. Irwin Graduate School at The American College. He is internationally known for his research on mutual funds and regularly teaches a course on mutual funds in The American College’s Master of Science in Financial Services program. Learn more about his research at ssrn.com/author=843211.
In 2012, I published a literature review in the Journal of Financial Service Professionals on the characteristics of actively managed mutual funds that are indicative of future performance. The main takeaways were that a high level of fund manager ownership, board of director ownership, a short-term redemption fee, a high active share or low R-squared value, and being unaffiliated with an investment bank are all positively associated with future performance.
Since that paper was published, new research has revealed additional characteristics to consider when selecting mutual funds. In this month’s column, I discuss the four additional characteristics I believe are the most compelling for financial planners to look for. It should be noted that some of the papers reviewed in this month’s column are working papers and, as such, the results are subject to change.
Look for Funds that Manage Portfolios In-House
In a 2013 paper, “Outsourcing Mutual Fund Management: Firm Boundaries, Incentives, and Performance,” published by Joseph Chen, Harrison Hong, Wenxi Jiang, and Jeffrey D. Kubik in The Journal of Finance, the authors compared the performance of mutual funds that managed their portfolios in-house, versus those that outsourced the management of their portfolios to external investment advisory firms.
The funds that were managed in-house outperformed those that were managed by external investment advisory firms by about 50 basis points per year. The authors believe that this is likely because the interests of the managers are more aligned with those of the investors when the managers are directly employed by the funds.
Oftentimes, when a mutual fund outsources the management of its portfolio, it will outsource it to an investment advisory firm that also has its own brand of funds. In a 2015 Journal of Finance paper, “Outsourcing in the International Mutual Fund Industry: An Equilibrium View,” Oleg Chuprinin, Massimo Massa, and David Schumacher illuminated particularly egregious conflicts of interest that occur in these investment advisory firms. The authors conducted a battery of empirical tests that showed that such firms give preferential treatment toward their own mutual funds over funds that they manage on behalf of other mutual fund families.
For example, the authors showed that such firms place better trades in their own funds and more heavily weight their own funds’ portfolios toward stocks that recently had an initial public offering. Moreover, they will use the funds that they manage on behalf of other fund families as liquidity providers to cheaply accommodate a shock to redemption requests in their own mutual funds. Chuprinin, Massa, and Schumacher provided empirical support for the “conflicts of interest” explanation that Chen, Hong, Jiang, and Kubik espoused for their finding that funds managed by external investment advisory firms underperformed those managed in-house.
Look for Funds that Outsource Tasks Unrelated to Portfolio Management
In the working paper, “Outsourcing of Mutual Funds’ Non-Core Competencies,” Christoph Sorhage compares the performance of mutual funds that administer their shareholder services in-house versus those that outsource these non-core tasks to external firms. He finds that funds that outsource all of their shareholder services outperform their counterparts by 39 to 253 basis points per year, depending on metric of performance and performance regression model specification.
Sorhage believes that this is likely because funds that outsource their non-core tasks are more focused on performing their core task of portfolio management. He documents that funds that outsource all of their shareholder services have statistically significantly higher active share values and lower R-squared values than their counterparts. This shows that funds that outsource their non-core tasks exert greater effort in selecting securities to hold in their portfolios, and that supports Sorhage’s idea that these funds are more focused on managing their portfolios.
Look for Funds that Compensate Managers with Performance-Linked Bonuses
In 2005, the SEC adopted Rule S7-12-04, which requires mutual funds to disclose information on how their portfolio managers are compensated in their Statement of Additional Information (a document that they must provide to prospective investors upon request). In the working paper, “Portfolio Manager Compensation in the U.S. Mutual Fund Industry,” Linlin Ma, Yuehua Tang, and Juan-Pedro Gómez gather this data to evaluate the impact of mutual fund portfolio manager compensation structure on fund performance.
The authors found that 77 percent of funds link the pay of their portfolio managers directly to the investment performance of the portfolios that they manage, and that they outperform their counterparts by 40 to 73 basis points per year, depending on metric of performance. The authors explain that this indicates that performance-linked bonuses are an effective mechanism of aligning the interest of the portfolio manager with that of his or her investors.
Another requirement of SEC Rule S7-12-04 is that funds that compensate their managers with performance-linked bonuses disclose the length of their performance evaluation period and the benchmark that they are evaluated against. Ma, Tang, and Gómez find that a one-year increase in the length of the performance evaluation period of such funds corresponds to a 14 to 20 basis point increase in annual performance, depending on metric of performance and performance regression model specification. This is likely because a longer evaluation period mitigates “managerial short-termism” and is more likely to reward skill rather than luck.
While SEC Rule S7-12-04 requires that funds that compensate their managers with performance-linked bonuses identify any benchmark used to measure performance, Ma, Tang, and Gómez find that only around 80 percent of such funds do. Interestingly, the impact of the length of the performance evaluation period on fund performance is stronger amongst a subsample of such funds that clearly state a benchmark. Ma, Tang, and Gómez find within this subsample of funds, a one-year increase in the length of the performance evaluation period corresponds to a 19 to 30 basis point increase in annual performance (again, depending on metric of performance and performance regression model specification).
In summary, the practical takeaways from the Ma, Tang, and Gómez study are that financial planners should pay attention to the disclosures that mutual funds provide in their Statement of Additional Information on how their portfolio managers are compensated. They should look for funds that link the pay of their portfolio managers directly to the investment performance of their portfolios, that evaluate the performance of their managers over a period of more than three years, and that clearly specify the benchmark that they use to measure performance.
Look for Funds with a Ph.D. in the Family
In the working paper “What a Difference a Ph.D. Makes: More than Three Little Letters,” Ranadeb Chaudhuri, Zoran Ivković, Joshua Pollet, and Charles Trzcinka evaluate the performance of domestic equity products offered by firms in which at least one key role is performed by an individual with a Ph.D. degree. They find that these “Ph.D. products” outperform their counterparts by 78 basis points per year based on alpha from Carhart’s Four-Factor Model. The authors also use a sophisticated technique to gauge whether the field of study of the individual performing a key role matters. They find some evidence that suggests that those who earned a doctorate in finance, economics, or a related field outperform those who earned a doctorate in another discipline.
Over the past three years, academic research has revealed new characteristics to look for in an actively managed mutual fund. In 2012, I suggested that financial planners look for funds with a high level of fund manager ownership, board of director ownership, a short-term redemption fee, a high active share or low R-squared value, and that lack affiliation with an investment bank. Recent research shows that financial planners should also look for funds that manage their portfolios in-house, outsource the execution of their shareholder services, have managers with performance-linked bonuses, and have a key role in their fund family performed by someone with a Ph.D. Each of these characteristics are associated with outperformance.