MARKET EFFICIENCY & MUTUAL FUNDS

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1 MARKET EFFICIENCY & MUTUAL FUNDS Topics: Market Efficiency Random Walks Different Forms of Market Efficiency Investing in Mutual Funds Introduction to mutual funds Evaluating mutual fund performance Evaluating mutual fund investors Evaluating mutual fund recommendations Why aren t index funds more popular? Market Efficiency Assume that government bonds, preferred stock, and common stock are all priced appropriately. When you buy the government bond today and sell it next year, your expected rate of return is the risk-free rate of return. When you buy the preferred stock today and sell it next year, your expected rate of return is the required rate of return on preferred stock. When you buy the common stock today and sell it next year, your expected rate of return is the required rate of return on common stock. In each case, the NPV of the transaction is zero. The only way for you to earn a positive NPV is to know the current price is too low (hard) or the future price will be too high (harder). Defining Market Efficiency: If markets are efficient then asset prices today reflect all currently available information. 1

2 Random Walks Defining a Random Walk: Tomorrow s change in a stock s price is independent of today s change in the stock s price. Consider a simple $100 bet. Flip a fair coin many times. If heads, you earn a positive 5% return. If tails, you earn a negative 4% return. On average, you earn a positive return, but today s return tells you nothing about tomorrow s return. Previous experiment is completely random. Your investment goes up or down based on coin flips. If we compare the results of lots of coin flips with the stock market, it is hard to tell them apart. If stock prices follow a random walk, the recent stock returns provide no information about future stock price returns. Clearly, the coin flip experiment is a random experiment. Since stock prices look similar we might infer that stock prices follow a random walk. And there is lots of academic research that supports this view 2

3 In contrast, technical analysis searches for patterns in stock prices and bases trades on these patterns. There is little evidence that anyone has consistently beaten the stock market using technical analysis. How do technical analysts survive? Luck. Institutional investors are constantly looking to exploit naive retail investors. An efficient market is one in which profitable opportunities are quickly exploited. Weak Form Efficiency Weak form market efficiency says that all information from the history of past prices is currently incorporated into today s price. Security prices rapidly reflect all information contained in the past security prices Random walk Technical analysis Weak form efficient stock market should follow a random walk Evidence in support of weak form efficiency: Correlation between last periods return and today s return tends to be small and insignificantly different from zero. Experiment above is fairly compelling. I can t tell the difference between the valueweighted index and the coin flip experiment without additional information (e.g., Black Monday was 10/19/87) Evidence against weak form efficiency: Momentum Relative returns over past 3, 6, 12 months predicts relative returns over next 3, 6, 12 months Is it possible that institutional investors systematically underreact to news? Semi-Strong Form Efficiency Semi-strong form market efficiency says that all publicly available information is incorporated into today s prices. Security prices rapidly reflect all publicly available information Fundamental analysis Fundamental analysis uses the news and published material on each company to determine its financial health, business prospects, and the effect that innovations in the marketplace will have on its fortunes. 3

4 Evidence in support of semi-strong form efficiency comes from the fact that stock prices respond to corporate announcements: Earnings and dividend change announcements Changes in analyst buy recommendations Mergers and acquisition activity (e.g. Comcast and Disney) Studies find that stock prices react to new announcements nearly immediately and without much correction afterwards (e.g., iphone introduction) Markets appear to be semi-strong form efficient. Strong Form Efficiency Strong form market efficiency says that all value-relevant information is incorporated into today s prices. Security prices rapidly reflect all relevant information about asset values. Professional portfolio managers There is some evidence in support of strong form efficiency: Mutual funds and other professional money managers consistently fail to beat the market But lots of evidence against strong form efficiency: Stock market responds to trades by corporate insiders. Investors with inside information appear to earn abnormal positive returns (before they go to jail!) Is it surprising that the market is not strong form efficient? No. If it were, no one would have an incentive to gather the information that makes the market efficient paradox (Grossman and Stiglitz (1980)) Introduction to Mutual Funds We just learned that financial markets are likely semi-strong efficient. This implies that you are unlikely to consistently beat the market from one year to the next. Previously, we learned that diversification is a good thing By adding more and more stocks to our portfolio we can eliminate risk associated with company specific events, leaving only systematic risk (which is the only risk financial markets compensate you for bearing). 4

5 We also learned that investments in common stock have outperformed less risky investments over long investment horizons: Annual return on treasury bills 3.8% Annual return on common stocks 12.4% Just because you can t expect to beat the market doesn t mean that you shouldn t invest in a diversified portfolio of stocks and bonds. A mutual fund is a diversified portfolio of stocks and/or bonds that is managed on your behave Value of your investment rises and falls as the fund s after-fee return rises and falls When you purchase shares, an open-end mutual fund uses your money to increase the size of its portfolio Purchasing shares in a mutual fund is almost always cheaper than building a diversified portfolio of individual stocks and bonds Shares can typically be purchased with minimum investment of $500 for an IRA; $1000- $5000 for non-tax advantaged account Purchase and sales orders are processed at the end of the day Mutual Funds are Widely Held 5

6 Mutual Fund Assets Under Management ($ trillions) All Funds Equity Funds Source: Investment Company Institute 2011 Fact Book Thousands of Mutual Funds to Choose From Open-end funds differ in terms of investment objectives... Large Capitalization vs. Small Capitalization Growth vs. Value - SEI Large Cap Growth Fund vs. Compass Small Cap Value Fund Domestic vs. International - Vanguard S&P 500 Index Fund vs. Loomis Sayles International Equity Fund Target Date Retirement Funds portfolio of stocks and bonds that reduces exposure to equity as you get close to target retirement year - Examples include Fidelity Freedom 2020 Fund and T. Rowe Price Retirement 2040 Fund - Popular default retirement option within 401(k) retirement plans (thanks to the Pension Protection Act of 2006) 6

7 Active or Passive? In 2010, mutual funds held 27% of all U.S. equity. There are two different approaches to investing Active Funds actively buy and sell stocks throughout the year with the goal of beating the S&P 500 index (or some other benchmark) Peter Lynch (BC 65) earned significant returns for investors in the Fidelity Magellan Fund between 1977 and 1990 Index Funds buy and hold stocks and bonds with the goal of passively matching the return of a benchmark portfolio Between 1996 and 2010, percentage of equity mutual assets under management in index funds rose from 5.2% to 14.5% In 2010, 37% of index fund asset under management were in index funds benchmarked to the S&P 500 Source: Investment Company Institute 2011 Fact Book Mutual Fund Expenses Perhaps most importantly, open-end funds differ in their expenses Index Funds charge ~ 0.15% per year (for a large S&P 500 index) Active Funds charge ~ 1.00% per year Load Funds charge you a sales commission, either 3-5% upfront or an extra 1% per year forever; loads are paid to the broker who guides you to the mutual fund No-Load Funds do not charge a sales commission, but offer less guidance on how to invest and less hand holding Each dollar that you pay in fees (unrelated to portfolio management) mechanically reduces the value of your investment by one dollar Each dollar you pay in fees for portfolio management may also reduce the value of your investment by one dollar All About Mutual Fund Performance Do actively managed funds outperform index funds? No! Actually, on average, index funds outperforms active funds. 7

8 There is some evidence that active funds outperform index funds on a before-expense basis, but you cannot earn the before-expense returns! Fact that investors continue investing in active funds Puzzle of Active Management (Gruber (1996), French (2008)) Are actively managed funds that outperform this year more likely to outperform next year? No! This is very little evidence that mutual fund managers can persistently beat the market However, there is strong evidence that managers charging high fees can persistently underperform the market (Carhart (1997)) Many Mutual Funds Sold Through Advisers Mutual Fund Performance Are mutual funds sold through brokers better than mutual funds sold directly to investors? No! They underperform by about 1 percent per year even if you add back the fees paid to brokers (Bergstresser, Chalmers & Tufano (2009)) Actively managed direct-sold funds earn significantly higher after-fee returns (Del Guercio and Reuter (2012)) 8

9 Why do investors continue to buy actively managed funds? Puzzle of active management is driven by the fact that active funds sold through brokers underperform index funds sold through brokers demand for financial guidance becomes demand for active funds Actively managed funds may outperform in down markets, when losses are the most painful to risk-averse investors (Glode (2011)) Financial media tends to recommend active funds over index funds Active Growth Funds vs. Index Funds Source: Center for Research in Security Prices 9

10 How Do Individual Investors Pick Mutual Funds? Investors should chase low expenses; instead they chase past returns Source: Sirri and Tufano (1998) How Do Magazines Pick Mutual Funds? They Chase Returns & Reward Advertisers! Note: Figures reported are per year averages over the five years that we have both Money s list composition and CMR s advertising expenditure data ( ) Source: Reuter and Zitzewitz (2006) 10