Another Puzzle: The Growth In Actively Managed Mutual Funds. Professor Martin J. Gruber

Another Puzzle: The Growth In Actively Managed Mutual Funds Professor Martin J. Gruber

Bibliography Modern Portfolio Analysis and Investment Analysis Edwin J. Elton, Martin J. Gruber, Stephen Brown and William Goetzmann, John Wiley and Sons, Sixth Edition, 2003 2

The Performance of Publicly Offered Commodity Funds Edwin J. Elton, Martin J. Gruber and Joel C. Rentzler, Financial Analysts Journal, July-August 1990 New Public Offerings, Information, and Investor Rationality: The Case of Publicly Offered Commodity Funds Edwin J. Elton, Martin J. Gruber and Joel C. Rentzler, Journal of Business, January 1989 Professionally Managed Publicly Traded Commodity Funds Edwin J. Elton, Martin J. Gruber and Joel C. Rentzler, Journal of Business, April 1987 3

Efficiency With Costly Information: A Reinterpretation of Evidence From Managed Portfolios Edwin J. Elton, Martin J. Gruber, Sanjiv Das and Matthew Hlavka, The Review of Financial Studies, 1993 The Performance of Bond Mutual Funds Christopher R. Blake, Edwin J. Elton and Martin J. Gruber, Journal of Business, July 1993 Fundamental Economic Variables, Expected Returns, and Bond Fund Performance Edwin J. Elton, Martin J. Gruber and Christopher R. Blake, Journal of Finance, September 1995 Survivorship Bias and Mutual Fund Performance Edwin J. Elton, Martin J. Gruber and Christopher R. Blake, The Review of Financial Studies, Winter 1996 4

The Persistence of Risk-adjusted Mutual Fund Performance Edwin J. Elton, Martin J. Gruber and Christopher R. Blake, Journal of Business, April 1996 Another Puzzle: the Growth in Actively Managed Mutual Funds Martin J. Gruber, Journal of Finance, June 1996 Do Investors Care About Sentiment? Edwin J. Elton, Martin J. Gruber and Jeff Busse, Journal of Business, October 1998 Common Factors in Mutual Funds Returns Edwin J. Elton, Martin J. Gruber and Christopher R. Blake, European Finance Review, November 1999 5

Spiders: Where Are the Bugs? Edwin J. Elton, Martin J. Gruber George Comer and Kai Li, Journal of Business, June 2002 A First Look at the Accuracy of the CRSP Mutual Fund Database and Comparison With Morningstar Data Edwin J. Elton, Martin J. Gruber and Christopher R. Blake, Journal of Finance, December 2001 Incentive Fees and Mutual Funds Edwin J. Elton, Martin J. Gruber and Christopher R. Blake, Journal of Finance, April 2003 Are Investors Rational: Choices Among Index Funds Edwin J. Elton, Martin J. Gruber and Jeff Busse, Journal of Finance, February 2004 6

U.S. Mutual Funds by Type (market value) Money Market 24% Fixed Income 16% Equity 60% Based on 1/30/05 Assets Total $8.00 Trillion 7

Growth of Mutual Funds by Type 5000 4500 4000 Billions of U.S. Dollar 3500 3000 2500 2000 1500 1000 500 0 1970 1973 1976 1979 1982 1985 1988 1991 1994 Bond & Income Money Market Equity 1997 2000 2003 8

9

Growth of U.S. Mutual Funds by Type (Market Value) Year Money Market Bond & Income Equity Total 1975 4 5 38 47 1980 76 14 44 134 1985 244 135 117 496 1990 498 323 246 1067 1995 753 798 1269 2820 1997 1059 724 2685 4468 1999 1612 808 4423 6843 2000 1845 811 4363 7019 2001 2285 925 3765 6975 2002 2272 1125 2995 6392 2003 2053 1241 4119 7413 2004 1900 1300 4800 8000 5 year avg. 8.7% 10.0% 1.6% 3.2% 10

Growth of U.S. Mutual Funds by Type (Market Value) Year Money Market Bond & Income Equity Total 1975 4 5 38 47 1980 76 14 44 134 1985 244 135 117 496 1990 498 323 246 1067 1995 753 798 1269 2820 1997 1059 724 2685 4468 1999 1612 808 4423 6843 2000 1845 811 4363 7019 2001 2285 925 3765 6975 2002 2272 1125 2995 6392 2003 2053 1241 4119 7413 2004 1900 1300 4800 8000 5 year avg. 8.7% 10.0% 1.6% 3.2% 11

Percent of U.S. Households Owning Mutual Funds 60% 50% 49% 52% 50% 48% 48% 44% 40% 37% 30% 24% 25% 27% 31% 20% 20% 10% 6% 11% 12% 0% 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2001 2002 2003 2004 Inside employees sponsored plans 32.5% Outside employee sponsored plans 35.1% 12

Average Performance Index Funds Closed End Funds The Persistence Of Performance Expenses What Accounts For Cash Flow How Well Do Investors Do 13

Customer Services including record keeping, the ability to move money around among funds, and daily valuation Low Transaction Costs Low Cost Diversification Professional Management (security diversification) 14

Open end mutual funds sell at the net asset value. If good management exists, a fund which has superior management will sell at net asset vale. If bad management exists, a fund which has inferior management will sell at net asset value. Management is not priced. Counter argument. 15

16 i F M Mi i F i e R R R R + + = ) ( β α R i R F α i M β i ( ) ( ) ( ) ( ) i F B Bi V G Gi L S Si F M Mi i F i e R R R R R R R R R R + + + + + = β β β β α i i R M R α =

Return Per Year Years Manager A Manager B Manager C 1971-75 3.2% 0.6% 0.8% 1976-80 13.9% 37.4% 36.1% 1981-85 14.7% 18.8% 19.2% 1986-90 13.1% 0.6% 1.0% 1991-95 14.8% 24.5% 24.4% 1996-2000 18.4% 10.9% 11.1% 17

Return Based Style Analysis Excess Return On Fund = Constant Excess Sensitivity + Return on to S& P S& P + Return on Sensitivity Small Minus + to Size Large Index Sensitivity Return on Sensitivity Excess + + to Growth Minus to Bond Return on + Random Growth Value Index Index Bond Index 18

Average Performance R i -R M α β M ρ Open End -1.944-1.560 0.963 0.810 Nonsurviving -5.184-4.200 0.929 0.710 α β M β S β G β B ρ 2 Open End -0.648 0.850 0.314 0.229 0.090 0.886 Nonsurviving -2.748 0.781 0.391 0.290 0.095 0.801 19

Average Performance R i -R M α β M ρ Maximum Capital Gains -1.500-2.184 1.073 0.780 Growth -1.848-1.572 0.978 0.810 Growth and Income -2.556-0.876 0.829 0.840 α β M β S β G β B ρ 2 Maximum Capital Gains -0.420 0.889 0.466 0.433 0.092 0.897 Growth -0.540 0.860 0.306 0.264 0.077 0.886 Growth and Income -1.056 0.796 0.175-0.031 0.108 0.878 20

Index Funds 1985 3 S&P Funds 1.24% 1 Small Stock 0.88% No Growth, Value, or Bond Fund 1994 Over 100 Index Funds 44 S&P Funds 0.19-1.35% Good Tracking (R 2 =.997) Low Cost 21

Closed end funds sell at an average discount of 10% Investors are only willing to pay 90 cents for $1 in assets under management Why will they pay $1 for $1 under management in open end? Management is not priced in open end funds 22

Ranked By Previous 1-Year Alpha Decile 1 year alpha Bottom 1-2.592 2-1.080 3-0.444 4-0.528 5-0.240 6-0.468 7 0.528 8 0.060 9-0.156 Top 10 0.816 Spearman Rank 0.891 * * Top Bottom 3.408 * * Significant at 1% level ** Significant at 5% level 23

Ranked By Previous Expense Ratio Decile 1 year alpha High -1.716 2-0.948 3-0.828 4-0.012 5-0.024 6 0.120 7 0.564 8 0.156 9-0.216 Low -0.096 Spearman Rank 0.552 Low High 1.620 * * Significant at 1% level 24

Realized Annual Three Year Four Index Alpha Predicted By 3 Year Alpha Decile Bottom 1 2 3 4 5 6 7 8 9 Top 10 Spearman Rank Top Bottom * Significant at 1% level 3 year alpha -2.676-0.528-0.312-0.684-0.156-0.372 0.132 0.060 0.696 0.876 0.903 * 3.564 * 25

Realized Annual Three Year Four Index Alpha Predicted By Expense Ratio Decile High 2 3 4 5 6 7 8 9 Low Spearman Rank Low High Expense ratios are reported from high to low * Significant at 1% level Exp Ratio -1.716-0.948-0.828-0.012-0.024 0.120 0.564 0.156-0.216-0.096 0.552 1.620 * 26

Expense Ratios for Deciles Formed on the Basis of Four Index Alphas: Decile (t) 1 2 3 4 5 6 7 8 9 10 t 1.357 1.050 1.018 0.960 0.971 0.955 0.973 1.035 1.027 1.042 t+1 1.405 1.061 1.007 0.968 0.994 0.962 0.986 1.016 1.043 1.052 t+2 1.413 1.068 1.031 0.984 1.029 0.970 0.998 1.053 1.037 1.048 t+3 1.415 1.084 1.064.0998 1.049 0.967 1.007 1.080 1.055 1.058 t+4 1.400 1.072 1.115 1.024 1.064 0.959 1.050 1.119 1.028 1.057 Mean 1.039 1.049 1.063 1.078 1.089 27

Annual Cash Flows for Deciles Formed on the Basis of Four Index Alphas in the Year Following Formation Decile 1 2 3 4 5 6 7 8 9 10 Spearman Rank Top Bottom * Significant at 1% level % Change in Cash Flow -15.4-11.2-5.1-5.0-3.7-2.4 4.5 6.6 12.8 29.0 1.00 * 1.620 * 28

Annual Realized Cash Flow Weighted Alpha Buy at End of Quarter Return on Cash Flows 1Quarter Holding Period 1Year 3 Years Positive 0.3516 0.2892 0.0396 Negative 0.8544 0.2244 0.0984 Weighted Avg. 0.5280 0.2652 0.0660 29

0. 80% 0. 60% Annual Average Alpha 0. 40% 0. 20% 0. 00% - 0. 20% 0 6 12 18 24 30 36-0. 40% - 0. 60% Months L. Zheng 30

1. Index funds outperform actively managed funds of the same risk Active funds 65b.p. below indexes. Charge fee of 130 b.p. Bring information worth 65b.p. but charge 130b.p. 2. Funds that charge higher fees tend to do worse that funds that charge lower fees 3. Funds that perform well have a slight tendency to continue to perform well Funds that perform really badly tend to continue to perform really badly 31

4. Investors seem to be aware of this. Funds that perform well have higher subsequent cash flows. Funds that perform badly have high cash out flows. 5. The result of this is that new investment and disinvestment earns a risk adjusted return slightly above that which would be earned on a set of index funds with the same risk. 32

A. A sophisticated clientele. B. A disadvantaged clientele. 1. Unsophisticated investors 2. Institutionally disadvantaged investors 3. Tax disadvantaged investors 33