1 The tmng ablty of hybrd funds of funds Javer Rodríguez* Graduate School of Busness Admnstraton Unversty of Puerto Rco PO San Juan, PR Abstract Hybrd mutual funds are funds that nvest n a combnaton of stocks and bonds. Hybrd funds of mutual funds are funds that hold shares of other equty and fxed ncome mutual funds. Ths fundamental dfference between these two types of hybrd funds makes them an deal laboratory to examne ther stock market tmng ablty. Usng daly fund and ndex data I mplement a mult-factor tmng model whch successfully controls for the fxed ncome exposure of hybrds funds. I fnd that as a group both types of hybrd funds faled to correctly tme the market. JEL: G11; G20 Keywords: Funds of funds; hybrd funds; market tmng ablty. * Author s emal address:
2 2 The tmng ablty of hybrd funds of funds Abstract Hybrd mutual funds are funds that nvest n a combnaton of stocks and bonds. Hybrd funds of mutual funds are funds that hold shares of other equty and fxed ncome mutual funds. Ths fundamental dfference between these two types of hybrd funds makes them an deal laboratory to examne ther stock market tmng ablty. Usng daly fund and ndex data I mplement a mult-factor tmng model whch successfully controls for the fxed ncome exposure of hybrds funds. I fnd that as a group both types of hybrd funds faled to correctly tme the market. 1. Introducton Funds of funds (FOFs) are mutual funds that hold shares of other mutual funds. Recently, FOFs have sgnfcantly grown n popularty. Accordng to statstcs from the Investment Company Insttute (ICI), durng the tme perod of ths study the number of FOFs has more than doubled n sze whle assets have grown exponentally. In 1999, there were 212 funds wth total net assets of $48 bllon of dollars, as of the end of 2009 these numbers were 932 funds and $673 bllon of dollars respectvely. Fnally, whle equty mutual funds had net outflows durng the 2010, FOFs receved $134 bllon n net new cash flow n Although the popularty of FOFs s unquestonable, very few academc studes are exclusvely dedcated to them. To the best of my knowledge, Bertn and Prather (2009) s the only academc paper solely devoted to open-end FOFs and reports evdence of outperformance by FOFs when compared wth tradtonal equty mutual funds 1. 1 Some papers look at hedge funds of funds, for example Brown, Goetzman and Lang (2004). Real estate mutual funds are sometmes regarded as funds of mutual funds as n Chang, Kozhevnkov, and Lee (2008).
3 3 Hybrd-FOFs, the subject of ths study, s the most popular type of FOFs, accountng for as much as 80 percent of the funds of funds total net assets 2. Hybrd-FOFs nvest n a combnaton of stock, bond and money market mutual funds, provdng nvestors wth a dversfed portfolo at a reasonable prce. Although each fund s dfferent, hybrd-fofs wll normally hold between 3 and 20 mutual funds and nvest 30%-70% of ther assets n equty funds, 30%-60% n fxed ncome funds, and between 0% and 30% n money market funds 3. The vast majorty of hybrd-fofs are actvely managed. Ther managers have more nvestment flexblty than tradtonal equty mutual funds whch allow then to alter ther portfolos confguraton n response to changng market condtons. Hybrd-FOFs are smlar to tradtonal hybrd funds. They both offer nvestors a dversfed portfolo whch ncludes exposure to the equty, fxed ncome, and cash sectors of the market. Fund managers of both types of hybrd funds have a greater degree of nvestment flexblty n comparson to those of tradtonal equty or fxed ncome funds. Ths greater degree of nvestment freedom allows fund managers to actvely change ther portfolos mx n response to, or n antcpaton of, market swngs. However, hybrd-fofs and hybrd funds do sgnfcantly dffer n the type of assets they hold. Hybrd-FOFs hold shares of other mutual funds whle hybrd funds hold ndvdual securtes. Gven ths fundamental dfference between tradtonal hybrd funds and hybrd-fofs, I set up to answer the followng queston: n comparson to hybrd funds, do hybrd-fofs better tme the market? Market tmng s an nvestment strategy n whch fund managers try to dentfy the best tmes to be n or out of the market. To be successful n ths strategy, fund managers must effectvely forecast market peaks and troughs and rebalance ther portfolo holdngs accordngly. 2 Accordng to data provded by the Investment Company Insttute. 3 Bertn and Prather (2009) report that ther 2003 sample held a medan number of 18 funds.
4 4 The tmng ablty of mutual fund managers s stll a very actve research topc 4. Gven that hybrd funds hold ndvdual securtes whle hybrd-fofs hold other funds- and both types of funds have a hgh degree of nvestment flexblty- they make them an deal laboratory to study market tmng ablty. When hybrd funds go to the market to rebalance ther portfolos, they ncur n transactons costs whch, based on Carhat (1997) and Wermer (2000), are sgnfcant. On the other hand, when hybrd-fofs change ther portfolo mx they just transfer funds between other (most commonly n-house) mutual funds, whch can be a less costly alternatve. Whether or not ths dfference n costs translates to savngs for hybrd-fofs shareholders s stll unknown. There s also another sgnfcant dfference between hybrd funds and hybrd-fofs when t comes to rebalancng ther portfolos. When a hybrd fund manager decdes to alter the fund s portfolo, she s the one decdng whch securtes to buy or sell. However, when a hybrd-fofs manager makes the same decson, he does so by movng funds wthn a lst of dversfed portfolos, perhaps wth the consequence of dlutng the effect of the manager s orgnal decson. In a way, hybrd fund managers take mcro-level decsons whle hybrd-fofs managers take macro-level decsons. Addtonally, hybrd-fofs managers are not only relyng on ther own abltes to forecast market movements but also bettng on the abltes of other fund managers to outperform a benchmark and provde value to fund shareholders. Ths feature of hybrd-fofs makes them resemble team-manage funds, a practce whch based on Fant and O Neal (1999) could lead to a hgh degree of portfolo dversfcaton and consequently lower levels of fund rsk. More recently, the evdence n Bar, Kempf, and Ruenz (2009) corroborate the rsk reducton benefts documented by Fant and O Neal (1999), but fnd some evdence of underperformance by team manage funds. 4 See for example Bollen and Busse (2004), Glassman and Rddck (2006), and Comer (2006).
5 5 Ths s not the frst tme the market tmng ablty of hybrd mutual funds s examned. Comer (2006) emprcally studes the tmng ablty of two dfferent samples of hybrd mutual funds durng two sample perods and fnds postve tmng ablty durng the tme perod. In a smlar approach of that of Comer (2006), Rodríguez (2008) examnes the market tmng ablty of global asset allocaton funds, the global verson of domestc hybrd funds. Rodríguez fnds evdence of poor market tmng ablty when the model specfcally controls for the fxed ncome component of the global asset allocaton funds portfolos. In ths study, I examne the market tmng ablty of a sample of 58 hybrd-fofs and a sze-matched sample of 116 tradtonal hybrd mutual funds. Gven the sgnfcant presence of fxed ncome mutual funds n the portfolos of hybrd funds of funds, I mplement a mult-factor model based on the work by Comer, Larrymore and Rodríguez (2009) whch specfcally controls for the presence fxed ncome securtes n mutual funds portfolos. I fnd evdence of perverse tmng ablty n the two samples of hybrd funds, FOFs and tradtonal. For the group of hybrd- FOFs the evdence s consstent across sample parttons based on fund characterstcs. I do fnd some evdence of good stock market tmng ablty for the hybrd funds wth the lowest expense rato and for the smallest n sze. The rest of the paper s organzed as follows: Secton 2 dscusses the methodology whle Secton 3 provdes a descrpton of the data. Emprcal results are presented n Secton 4, whle Secton 5 provdes the conclusons. 2. Methodology 2.1 Fund returns Snce I rely on fund returns to measure market tmng ablty, t s mperatve to use a return model whch effectvely ncorporates all the securtes whch spam the nvestment set of
6 6 tradtonal hybrd funds and hybrd-fofs. Comer, Larrymore, and Rodrguez (2009) (hereafter CLR) provde just that. After presentng evdence that all major classes of mutual funds, and specally hybrds, hold a sgnfcant porton of ther portfolos n fxed ncome securtes, CLR extends the Carhart (1997) model by addng a set of bond ndces to account for the fxed ncome exposure of hybrd funds. The evdence presented n CLR ponts to the fact that, when selectng hybrd funds, nvestors rely on the rsk adjusted performance based on models whch fal to account for the fxed ncome porton of hybrd fund s portfolo. The rsk adjusted performance based on Carhart s model s overestmated n comparson wth the two extensons of the Carhart s model presented n CLR. The authors conclude that the absence of bond ndces n Carhart s model msleads nvestors that rely on alpha to select funds. CLR propose two extensons of the Carhart (1997) model. These extensons nclude the four factors of Carhart s model plus bond ndces to account for the fxed ncome exposure n the funds portfolos. The work of Blake, Elton and Gruber (1993) and, more recently Comer (2006), serve as the bass to construct the extensons to the Carhart model presented n CLR. The frst model CLR consders n the Carhart sector model (C-sector model). Ths model ncludes bond ndces representng the dfferent sectors of the fxed ncome market. The model ncludes ndces for the government, credt, mortgage, and hgh yeld sectors. The second model n CLR s the Carhart maturty model (C-maturty model). The C-maturty model ncludes fxed ncome ndces for long maturty government/credt and ntermedate maturty government/credt, plus ndces for the mortgage and hgh yeld. In ths study I mplement a model of market tmng based on the C- maturty model. The C-maturty model from CLR can be express as follows:
7 7 r 8 j 1 j r j e. (1) Where, : measures rsk adjusted performance r : s the excess return of the fund. r j s: represents the excess returns on the followng factors: market portfolo, long maturty government/credt, ntermedate maturty government/credt, mortgage, hgh yeld ndces and the returns on the Fama-French (1993) sze factor, book-to-market factor, and the Carhart (1997) momentum factor. 2.2 Tmng model Treynor and Mazuy (1966) (hereafter TM) ntroduced a non-lnear model that measures the ablty of fund managers to decrease (ncrease) market exposure pror to a market fall (rse). The TM model tests for a nonlnearty effect as a result of tmng ablty. A fund managed by a successful market tmer wll have a non-lnear relatonshp wth the market; on the other hand, a mutual fund that does not engage n market tmng wll have returns lnearly related to those of the market. The TM approach has become one of the standards n the mutual fund lterature to test the stock market tmng ablty. I examne tmng ablty by mplementng a model whch combnes the TM approach wth the return formulaton n of the C-maturty model from CLR. That s, I add a quadratc market excess return factor to the C-maturty model of CLR to measure tmng ablty. Specfcally, I estmate the followng non-lnear regresson: r 8 j 1 j r j r 2 m e (2)
8 8 where: r : s the excess return of the fund and r m : s the excess return on the market ndex. A 0 provdes evdence of a fund manager wth good market tmng ablty. 3. Data The focus of ths study s on the tmng ablty of hybrd-fofs durng the January June 2010 tme perod relatve to the tmng ablty of a sample of tradtonal hybrd mutual funds. The hybrd-fofs sample s composed of all FOFs lsted on the December 1998 Mornngstar Prncpa CD wth a Mornngstar Category of domestc hybrd or an asset allocaton prospectus objectve. For funds wth multple share classes, I nclude only one fund class n the sample snce the management strateges are dentcal across the classes 5. The total number of hybrd-fofs n the fnal sample s 58. Each hybrd-fof s matched wth two tradtonal hybrd funds of smlar sze as measured by ther total net assets. In the end, the fund sample ncludes a total of 174 funds, 58 hybrd-fofs, and 116 hybrd funds. I use daly fund and ndex data to estmate tmng ablty. Bollen and Busse (2001) advocate the use of daly fund return data, as hgh frequency data mproves the model power specally when measurng tmng ablty. Table 1 here. Table 1 presents some of the descrptve statstcs of the sample. The nformaton presented n Table 1 s based on the data from the Center for Research n Securty Prces (CRSP) Mutual Fund Survvor-Bas Free Database. To estmate the values on the table, I frst collect all 5 For further detals see Lvngstone and O Neal (1998) and O Neal (1999).
9 9 the data for each fund and for the complete sample perod, then I average each fund s tme seres of data. Fnally, I compute the average value for all the funds n the sample. For the hybrd-fofs sample, the average total net assets, expense rato and turnover rato are 1094 mllons, 0.54% and 74.5% respectvely. In comparson wth tradtonal hybrd funds, hybrd-fofs are larger, have lower expense rato, and turnover ther portfolos at a lower rate. The table also presents some nformaton regardng the portfolo composton of these samples of funds. The average stock, bond, and cash allocatons for hybrd-fofs (hybrds funds) are: 60.81% (61.10%), 20.63% (31.16%), and 7.02% (4.08%) respectvely. I rely on daly fund and ndex return data to test stock market tmng ablty. The daly fund return data comes from CRSP. Daly data on the rsk free rate, the Fama-French factors, and Cahart s Momentum factor comes from the Kenneth French data lbrary webste 6. As n CLR, data on all bond ndces come from Lehman Brothers dataset. 4. Emprcal results 4.1 Portfolo exposures To better understand how well the C-maturty model explans the varaton n returns of the samples of hybrd-fofs and hybrd funds, I use the style methodology frst ntroduced by Sharpe (1992) 7. Style analyss allows for the estmaton of the fund s portfolo exposure to each market ndex from the publcly avalable fund returns. I estmate the portfolo exposure to all the factors n equaton 1 n a total return verson of the model. I restrct all the loadngs on the factors to be between zero and one, and to sum to one, except the loadngs on the factors of the zero nvestment mmckng portfolos of the Carhart s model. Table 2 shows the results of the style 6 7 CLR also employ Sharpe style analyss to examne portfolo exposure to the set of factors ncluded n ther models.
10 10 analyss performed on an equally weghted portfolo composed of all the funds n both samples durng the complete sample perod. Table 2 here. The evdence n Table 2 show that the model works well, explanng 97 percent or more of the varaton n fund returns. Also, for both samples, 7 out of 9 factor loadngs are statstcally sgnfcant at one percent. Smlar to the descrptve statstcs on Table 1, the style analyss reveals that on average hybrd-fofs hold less equty and more cash than hybrd funds. Regardng bond allocatons, the results show that on average hybrd funds hold less fxed ncome securtes than hybrd-fofs. However, both samples of funds hold a sgnfcant amount of fxed ncome securtes as the average total exposure to bonds ranges between 36.82% for hybrd funds and 44.58% for hybrd-fofs. Ths last pont provdes more support n favor of the use of the CLR model n estmatng the tmng ablty of hybrds funds. In the next secton I estmate the marketng ablty of both samples of hybrd funds by estmatng a tmng model based on the TM approach to measure tmng ablty and the CLR formulaton whch specfcally controls for the fxed ncome exposure of these funds. Specfcally, I estmate the C-maturty model (equaton 1) wth an addtonal quadratc term to measure tmng ablty. 4.2 Tmng ablty I estmate the market tmng ablty of each ndvdual fund, a total of 174, usng daly fund return and ndex data durng the January 1999 and June 2010 tme perod. Table 3 presents the results. Contrary to Comer (2006), I fnd evdence of negatve tmng ablty for both samples of funds. For the sample of hybrds-fofs, the average market tmng coeffcent s , whle
11 11 the medan coeffcent s However, both numbers are not statstcally sgnfcant. At the ndvdual fund level, 44 hybrd-fofs (more than 75% of the sample) attaned a negatve tmng coeffcent wth 14 coeffcents statstcally sgnfcant at the 5 percent level. On the other hand, 14 hybrd-fofs showed tmng ablty, and only 3 hybrd-fofs attaned a postve and sgnfcant tmng coeffcent. As a group, hybrd funds also show evdence of perverse tmng ablty. The average tmng coeffcent s whle the medan coeffcent s As s n the case of hybrd- FOFs, both the average and the medan coeffcents are not statstcally sgnfcant and the vast majorty of the hybrd funds attaned a negatve tmng coeffcent. A total of 75 funds, or 64% of the sample, have negatve market tmng coeffcents, wth 13 beng negatve and sgnfcant. Forty one hybrd funds have a postve tmng coeffcent wth only 13 of them statstcally sgnfcant at the 5 percent level. Table 3 here. Although the statstcal sgnfcance of the results s low, both sample of funds show perverse tmng ablty and the evdence s stronger for hybrd-fofs. The dfference between the average tmng coeffcent of hybrd-fofs and tradtonal hybrd funds s , although ths value s not statstcally sgnfcant. Also, n comparson wth the sample of hybrd funds, a larger porton of the sample of hybrd-fofs attaned a negatve tmng coeffcent. In sum, hybrd-fofs and hybrd funds fal to successfully shft ther portfolo holdngs wth the msson of tmng the stock market. Gven ths evdence of poor tmng ablty, n the next secton I explore the relatonshp between tmng ablty and observable fund characterstcs. 4.3 Tmng ablty and fund characterstcs
12 12 The prevous secton presented evdence of perverse tmng ablty by both hybrd-fofs and hybrds funds. In ths secton I examne the correlaton, f any, between tmng ablty and observable fund characterstcs. I consder three varables whch are standard n the mutual fund lterature: total net assets, expense rato, and turnover rato. The fund data comes from CRSP and t s the same data presented on Table 1. For each fund I used the average value of each characterstc and then sorted the funds nto quartles based on ther average. Gven these sorts, the frst quartle represents funds wth the lowest values for each characterstc. Fnally, for each quartle I compute the average tmng coeffcent. Table 4 presents the results. Table 4 here. The evdence of the poor tmng ablty of hybrd-fofs s wdespread. Regardless of the characterstc, all but one quartle have negatve average tmng coeffcent. The only quartle wth the postve coeffcent s the thrd quartle based on average expense ratos. For the sample of hybrd funds, the table shows some evdence of postve market tmng ablty. The smallest hybrd funds and the hybrd funds wth the hghest average expense ratos show good tmng ablty. Also, good tmng ablty s present n the mddle secton of the partton of hybrds funds based on turnover rato. In sum, regardless of the three fund characterstcs examned here, hybrd-fofs as a group faled to successfully tme the market. On the other hand, when the sample of tradtonal hybrd funds s parttoned based of fund characterstcs, some levels of fund characterstcs are correlated wth good tmng ablty. 4. Concluson Shares of hybrd funds of funds represent clams of portfolo consstng of a combnaton of equty and fxed ncome mutual funds. Hybrd funds of funds offer nvestors an actvely managed and dversfed portfolo at a sensble prce. Hybrd funds of funds are smlar to
13 13 tradtonal mutual funds, but dffer n some fundamental ssues. For example, hybrd funds of funds hold other funds and just transfer funds from one mutual fund to next when rebalancng ther portfolos. Tradtonal hybrds on the other hand, hold ndvdual securtes and must go to the market when they decde to alter ther portfolos. These sgnfcant dfferences make them an deal laboratory to examne market tmng ablty. In ths study I examne the market tmng ablty of hybrd funds of mutual funds and a sze-matched sample of tradtonal hybrd mutual funds durng the January 1999-June 2010 tme perod. To measure tmng ablty, I use daly fund return and ndex data and mplement a multfactor tmng model that ncludes both stock and fxed ncome ndces, whch make t deal to examne hybrd funds. I fnd that both samples of hybrds, funds of funds and tradtonal, fal to successfully tme the market. The perverse tmng ablty of hybrd funds of funds s worse than that of the tradtonal hybrd funds and wdespread regardless of sample parttons based on several fund characterstcs. On the other hand, the smallest n sze and the most expensve tradtonal hybrd mutual funds show good tmng ablty.
14 14 References Bar, Mchaela, Alexander Kempf, and Stefan Ruenz, Team manegement and mutual funds, 2009, workng paper, Unversty of Cologne. Bertn, Wllam J., and Laure Prather, 2009, Management structure and the performance of funds of mutual funds, Journal of Busness Research, 62, Blake, Chrstopher, Edwn Elton, and Martn Gruber, 1993, The performance of bond mutual funds, Journal of Busness 66, Bollen, Ncolas, and Jeffrey Busse, 2001, On the tmng ablty of mutual fund managers, Journal of Fnance 56, Bollen, Ncolas, and Jeffrey Busse, 2004, Short term persstence n mutual fund performance, Revew of Fnancal Studes 18, Brown, Stephen, J., Wllam N. Goetzmann, and Bng Lang, 2004, Fees on fees n funds of funds, Journal of Investment Management, 2(4) Chang, Kevn C.H., Krrl Kozhevnkov, Mng-Long Lee, and Crag H. Wsen, 2008, Further evdence of the performance of funds of funds: the case of real estate mutual funds, Real Estate Economcs 36(1) Comer, George, 2006, Hybrd mutual funds and market tmng performance, Journal of Busness 79,
15 15 Comer, George, Norrs Larrymore, and Javer Rodríguez, 2009, Controllng for fxed-ncome exposure n portfolo evaluaton: evdence from hybrd mutual funds, Revew of Fnancal Studes 22, Fama, Eugene, and Kenneth French, 1993, Common rsk factors n the returns on stocks and bonds, Journal of Fnancal Economcs 33, Fant, L. Franklng, and Edward O Neal, 1999, Do you need more than one manager for a gven equty style?, Journal of Portoflo Management 25(4) Glassman, Debra and Legh Rddck, 2006, Market tmng by global fund managers, Journal of Internatonal Money and Fnance, O Neal, Edward, S., and Page, D., E., 2000, Real Estate Mutual Funds: Abnormal Performance and Fund Characterstcs, Journal of Real Estate Portfolo Management, 6:3, O Neal, Edward, S., 1999, Mutual Fund Share Classes and Broker Incentves, Fnancal analyst Journal, 55:5, Rodríguez, Javer, 2008, Market tmng: a global endeavor, Journal of Internatonal Fnancal Markets Insttutons and Money 18, Sharpe, Wllam, 1992, Asset allocaton: Management style and performance measurement, Journal of Portfolo Management 18, Wermers, Russ, 2000, Mutual Fund Performance: an Emprcal Decomposton nto stock-pckng talent, style, transacton costs, and expenses, Journal of Fnance, 50,
16 16 Table 1 Descrptve statstcs Varable Hybrd-FOFs Hybrd funds Total net assets (mllon) (116) (85) Expense rato (n %) (0.39) (1.19) Turnover rato (n %) (39.5) (80.4) Stock allocaton (n %) (65.48) (61.27) Bond allocaton (n %) (14.56) (31.07) Cash allocaton (n %) (2.87) (3.86) Ths table presents descrptve statstcs for the sample of hybrd FOFs and tradtonal hybrd funds. All values n the table, except net assets, are n percentages. Medan values are n parenthess. The values are means are the cross secton mean across the values of all funds durng the January 1999-June 2010.
17 17 Table 2 Portfolo exposures for the maturty model Hybrds-FOFs Hybrd funds Market 49.13*** 57.11*** Sze 4.41*** -5.87*** Book to market 4.90*** 6.59*** Momentum Intermedate 21.97*** 23.49*** Long 0 0 Mortgage 11.98*** 9.75*** Hgh yeld 10.63*** 3.58*** Cash 6.28*** 6.06*** Adjusted r Ths table presents the average percentage exposure to the factors ncluded n the maturty model for the sample of hybrds funds of funds and tradtonal hybrd funds. ***, **, * denotes statstcal sgnfcance at the 1, 5 and 10 percent level respectvely.
18 18 Table 3 Dstrbuton of market tmng coeffcents Hybrd-FOFs Hybrds funds Mean Medan Std. Devaton Maxmum Mnmum Postve coeff Negatve coeff Ths table presents the results of the estmaton of the market tmng coeffcents based on the maturty model for the sample of hybrds funds of funds and hybrd funds. ***, **, * denotes statstcal sgnfcance at the 1, 5 and 10 percent level respectvely.
19 19 Table 4 Tmng ablty and fund characterstcs Panel A: Total Net Assets Quartle Hybrd-FOFs Hybrd funds Panel B: Expense Rato Quartle Hybrd-FOFs Hybrd funds Panel C: Turnover Rato Quartle Hybrd-FOFs Hybrd funds The table presents a comparson of the average tmng coeffcents three parttons of the two fund samples sample based on fund characterstcs. Funds are sorted by ther average total net assets, expense rato, and turnover rato and dvded nto quartles wth the frst quartle representng funds wth lowest value of each of the characterstcs. For each quartle the average tmng coeffcent s presented. Data on fund characterstcs comes from CRSP.