Can Mutual Fund Families Affect the Performance of Their Funds?

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1 Can Mutual Fund Families Affect the Performance of Their Funds? Ilan Guedj and Jannette Papastaikoudi MIT - Sloan School of Management First Draft - August 2003 This Draft - January 2004 Abstract We examine whether mutual fund families affect the performance of the funds they manage. From a sample of funds belonging to large families we find that last year s best performing funds outperform last year s worst performing funds by 58 basis points. We also show that there exists persistence of performance of these funds inside their respective families. This persistent excess performance is related to the number of funds in the family which we interpret as a measure of the latitude the family has in allocating resources unevenly between its funds. Supporting these findings, we also show that the better performing funds in a family have a higher probability of getting more managers, one of the main resources available. This is consistent with the view that fund families allocate resources in proportion to fund performance and not fund needs. We would like to thank John Chalmers, Joseph Chen, Denis Gromb, Dirk Jenter, Paul Joskow, Ajay Khorana, Jonathan Lewellen, Stewart Myers, Stefan Nagel, Anna Pavlova, Steve Ross, Antoinette Schoar, Henri Servaes, Peter Tufano, and the participants of the 2003 Transatlantic Conference at LBS for their helpful comments. Corresponding Author: Ilan Guedj, MIT Sloan School of Management, E52-442, 50 Memorial Drive, Cambridge MA, 02142, USA or 1

2 1 Introduction The mutual fund industry has grown at an incredible rate in the past years, showing an explosive increase particularly over the last decade. However, the recent revelations about the expropriation of investors trust and wealth by mutual fund families have shaken investors confidence and have brought the mutual fund industry under a lot of scrutiny. So far, we have witnessed preferential treatment of certain clients by allowing market timing and after hours trading. A legitimate question arises whether there have been other forms of preferential treatment that affect directly the observable performance of mutual funds. Towards that end, we ask whether mutual fund families can and indeed do affect the performance of their funds in a way that might systematically discriminate certain investors. One of the most extensively researched questions is whether mutual funds have persistent abnormal returns. If so, this provides evidence for the existence of superior managerial investment ability. In fact, persistence is well documented. Lehmann and Modest (1987), Hendricks, Patel and Zeckhauser (1993) and Wermers (1997), among others, have found evidence of persistence in fund performance over short horizons of one to three years. Yet, Brown and Goetzmann (1995) conclude that even if there is some predictability it is quite difficult to detect. Carhart (1997), Daniel, Grinblatt, Titman and Wermers (1997), Wermers (2000) and Pastor and Stambaugh (2002) argue that most of this persistence is due to factors other than managerial ability. In particular they show that positive abnormal returns can be attributed to momentum in stock prices while negative abnormal returns can be attributed to managerial expenses and transaction costs. In this paper we view mutual fund performance from a different perspective than the majority of the existing literature. Instead of treating a mutual fund as a completely independent entity, we view it as part of a larger group, the mutual fund family. Given this dependence, differences might arise between the objectives of the fund and the family it belongs to. Furthermore, these differences in objectives might potentially translate into discrepancies between expected and observed performance. In particular, if it serves the family s interest, it could decide to follow a strategy of selectively allocating its limited resources unevenly across its funds. The rationale behind such a strategy follows from both the convexity of the performance-flow relationship and flow spillovers inside the family. Spitz (1970), Chevalier and Ellison (1997) and Sirri and Tufano (1998) have documented that abnormal positive returns generate disproportionately more inflows than abnormal 2

3 negative returns would generate outflows. This implies that if the family had a choice between managing two mediocre performing funds or managing one well performing fund and one poorly performing fund, the family would prefer the latter combination. Apart from this empirical finding, it has also been observed by Khorana and Servaes (2002) and Nanda, Wang and Zheng (2003) that there exists a flow spillover within funds of families that possess at least one fund with an excellent performance record. The implication of this observation is equivalent to that of the convex performance-flow relationship: It is sufficient for the family to only have some well-performing funds in order to experience a large inflow in its assets under management. We therefore expect families to want to promote their funds selectively 1. However, in order to act along these lines, the family needs to possess the latitude to do so, i.e. it needs to have enough funds to be able to move resources from one to another. Hence, we hypothesize that one should expect larger families to be more capable of affecting the performance of their funds. To test our hypothesis, we use monthly open-end mutual fund data from the Center for Research in Security Prices (CRSP) for the period of Using a methodology similar to Carhart (1997) we analyze the persistence of the performance of mutual funds that belong to large families, defined either by the number of funds they hold or by their market capitalization. We find a short-term persistence in mutual fund performance. The difference in abnormal returns between a portfolio of funds which were last year s winners and a portfolio of funds which were last year s losers is 58 basis points per month (statistically significant at the 1% level), an annualized difference of 7.2%. In addition to these results, we perform the persistence methodology on a relative scale, i.e. when the funds are placed into portfolios with respect to their performance relative to other funds inside the same family. Again, we find a statistically significant difference between the top and bottom portfolio of 53 basis points per month, which translates into a difference of 6.5% per year in abnormal returns. The fact that persistence in fund performance is detected even within a mutual fund family can be viewed as evidence that families are actively intervening in their funds performance. 1 Some anecdotal evidence about selective promotion of funds has been provided in a case study by Loeffler (2003). He analyzes the case of the creation of a new class of pension funds. The three German mutual fund companies he follows enhanced the performance of the new funds by allocating underpriced IPOs to their portfolios. All that, in order to generate a favorable track record for the funds. 3

4 If the family is actively promoting some funds over others, it can accomplish this by unequal resource allocation. Managers (analysts) are one of the main resources families have both in actual terms and in the eyes of the investors. Chevalier and Ellison (1999a, 1999b) show that personal characteristics of the fund manager can help predict superior stock picking ability. Families seem to place serious consideration on this fact, since their decisions on managerial turnover is linked to the managers past performance. Khorana (1996, 2001) shows that a low performance of at least two years is necessary before a manager is removed from the management of the fund. He also shows that in the post-replacement period there is a significant improvement in the performance of the fund. Hu, Hall and Harvey (2000) analyze promotions and demotions of managers and conclude that there exists a positive relationship between the promotion probability and lagged fund returns. All these findings indicate that mutual fund families take their fund management very seriously and are not reluctant to intervene in their funds management, if needed. Hence, we can expect to observe family intervention which can potentially lead to preferential treatment of funds. In order to proxy an an attempt from the family to push certain funds, we use the probability of adding another manager to a fund. If our hypothesis is wrong one would expect that after controlling for fund characteristics, there would no longer be any statistically significant difference in the probability of adding a manager between funds in different groups of performance ranking. After using controls such as size and expenses we ask if within rankings, the probability of adding another manager depends on abnormal returns and lagged abnormal returns. We find that only funds in the top portfolio have a significant positive coefficient for their alpha, which would indicate that the decision to add a new manager depends positively on the fund s performance only when it is among the top in its family. Second, we ask if the probability of adding a manager given the funds past returns depends on the ranking group of the fund, i.e. on its relative performance against its peers in the same family. We find that the probability increases when a fund belongs to the top rank and decreases as the rank of the fund decreases. Lastly, we identify cases where only one manager was in charge of a fund and ask what the probability is of adding at least one new manager to such a fund. This question seems to be a more precise proxy for a deliberate action by the family, since the change from a single managed fund to a team managed fund is more substantial than adding another manager to an existing team. We find that again, the probability increases when a fund belongs to the top rank and decreases when the fund belongs to the bottom 4

5 rank. The remainder of the paper proceeds as follows. In section 2 we develop our hypotheses and methodology and describe the data. In section 3 we present our results and provide alternative explanations. In section 4 we perform probit regressions to further enhance our results. We conclude in section 5. 2 Hypotheses, Data and Methodology 2.1 Hypotheses A mutual fund is not a stand alone entity, but belongs to a broader organizational structure, the family. The family could impact the decisions of the fund, and thus could potentially have a significant effect on the fund, its performance and the persistence of this performance over time. In fact, there are two main reasons for the family to want to influence that performance. The first reason is the performance-flow relationship. Chevalier and Ellison (1997) and Sirri and Tufano (1998) have documented the existence of a convex relation between lagged fund performance and present fund flows: abnormal positive returns generate disproportionately more inflows than abnormal negative returns would generate outflows. This implies that if the family had the choice between owning two mediocre performing funds or one well performing fund and one poorly performing fund, the family would prefer the latter combination. This is the case because the convexity of the performance-flow relationship would translate into an increase of the net amount of assets under the family s management. Thus, it is reasonable to believe that faced with some better performing funds than others, the family would consciously choose to offer preferential treatment to the better ones in order to maintain their good track record, even if this would come at the expense of other poorly performing funds in the family. The convex performance-flow relation is not the only reason why a family would want to influence the performance of its funds. The second reason is that there exists evidence that flows are not independent across funds of the same family, on the contrary, there seems to exist a strong cross-sectional dependence. Khorana and Servaes (2002) find that a fund s market share within an investment objective is not only driven by its family s policies within that objective, there are important spillover effects from other funds within the same family 5

6 as well. Nanda, Wang and Zheng (2003) find that there is a strong positive spillover from a star performer to other funds within the same family. This spillover results in greater cash inflows not only to the star fund but to other funds in the family as well. As such, the cross sectional correlation between fund flows can increase aggregate inflows in a non-linear fashion and could be another incentive for the family to push the better performing funds in order to maintain their performance. Therefore, both the convexity of the flow-performance relation and the cross sectional correlation between fund flows imply that maximizing aggregate flows to the entire family is not necessarily equivalent to maximizing flows to each and every fund individually. In fact, and due to the cost of fund management, such a policy could even be sub-optimal. Instead, it seems to be sufficient for a family to have a few funds that persist at outperforming their peers; this would lead to increased flows to the entire family while being a more cost efficient strategy. Such a strategy that focuses on improving performance selectively and not to the entire universe of funds within a family might have direct implications on the observed behavior and performance of individual funds. The relevant question is which funds to promote in order to obtain the desired aggregate inflow effect to the family. Since investors look at past performance when deciding about the allocation of their wealth between funds 2, a family, if capable, would deliberately attempt to push its currently well performing funds also in the following year (after they had demonstrated good performance) in order for them to further increase their returns and therefore increase flows to the entire family 3. The family has several resources it can use in order to achieve this goal of pushing certain funds at the expense of others. The existence of a centralized research department, the waiving of management fees, and the ability to move managers from one fund to another or even share them among funds are only some of those resources that can be used and allocated not equitably between funds. Yet, even if it may be in the best interest of every family to act along these lines, not all are capable of adopting a fund promoting strategy, the main inhibition being the availability as well as the flexibility and latitude in allocating those resources. Evidently, larger families that offer a larger number and a greater variety of funds, have more flexibility in using their 2 Wilcox (2003) runs an experiment with investors and finds that performance is one of the most important determinants of investor choice. 3 In fact, Nanda, Wang and Zheng (2003) find that the empirically documented spillover effect from a star fund to other funds may induce lower quality families to pursue a star creating strategy. 6

7 resources in order to promote certain funds. Therefore, these families should exhibit a more pronounced fund-promoting behavior. We thus hypothesize that larger families are better equipped and are expected to act more along these lines than smaller families. Hence we expect to obtain two main findings. First, that funds belonging to larger families have a more persistent performance than funds belonging to smaller families. And second, given the strategy of the family to promote only a few of its funds, we expect to find persistence in fund performance also within a family. For example, even in a family where there isn t even one fund that performs well when measured in absolute terms, we still expect the family to push its relatively better funds to persist and improve. 2.2 Data Formation and Descriptive Statistics Data Our data originates from the Center for Research in Security Prices s Survivor-Bias Free US Mutual Fund Database (CRSP). This database is considered free of survivorship bias since it includes funds that no longer exist 4. Unfortunately it contains information on the fund families only from 1992 onwards. Therefore, although the CRSP mutual fund database is our primary source of data, we use complementary information to complete our study. Since we focus on the mutual fund family, we need to obtain accurate information on the families the funds belong to. Even though CRSP offers names of the fund family after 1992, it is often not consistent in their documentation across time and across funds. The implications thereof might affect adversely an analysis regarding families. As a precautionary measure we revert to the use of an alternative mutual fund database that has been commonly used in other mutual fund studies 5 : Morningstar. We use the Morningstar Principia Pro s CDs (Morningstar) for the years to cross-check our information on the fund families of our sample. This also allows us to extent the time period to If a fund does not possess such information it is dropped out of our sample. In a few cases where Morningstar does not provide the identify of the fund family, while CRSP possesses the information, the latter source is used. 4 Though, some studies have disputed whether CRSP is indeed survivorship-bias free. See Elton, Gruber, and Blake (2001) for an extensive analysis of this issue. 5 For example; Brown and Goetzmann (1997) Chevalier and Ellison (1999a, 1999b) and Hu, Hall, and Harvey (2000) among others. 7

8 In order to compare our results with the outstanding literature we keep only actively managed equity funds, hence funds that have an objective of Growth, Aggressive Growth, Growth and Income, Small Company and Equity Income 6. Therefore, we exclude Sector, International, Balanced, Bond, and Municipal funds. In addition, for a fund to enter our sample an additional requirement of one year of past reported returns is imposed. We use Morningstar as a consistent source for identifying the objectives of the funds. For the time period of interest we record 7,310 funds that meet these criteria. Next, we correct our sample for multiple share classes 7. To construct return series for the funds after share class aggregation, we value weight the returns of each individual class by class size. This reduces our sample to 3,046 funds. In our sample, each fund possesses on average 2.32 classes, 48.4% of the funds only have one share class. From those funds that possess more than one class, they possess on average 3.52 share classes. Our final sample incorporates 678 families across the years Not all of them exist throughout the entire sample. Acquisitions and mergers across families lead to some variation in the number of families appearing each year Descriptive Statistics In table 1 we provide annualized summary statistics of our sample. As one can note, the number of funds has more than tripled between 1990 and 2000, while remaining almost at a constant level during the recent years. This might be well due to the large amount of consolidation in the mutual fund arena in the past few years, as well as the recent low performance in the equity markets. The same pattern seems to appear for the average size of assets under management. The average amount of assets under management has more than quadrupled between 1990 and The table also includes some fund characteristics such as loads, fees and turnover. Loads are fees charged to the investor by the mutual fund, either when the fund is purchased (front-end load), when it is sold (rear-end loads) or depend on the amount of time the investor holds the fund (deferred loads). 12-B1 is an annual distribution charge (12b-1 fee) charged to the investor for marketing needs of the funds. Loads and fees show little to no variation across time in contrast to turnover that 6 Funds with these objectives have been identified by Morningstar as pure equity funds. 7 Mutual funds very often offer different types of shares supported by the same underlying portfolio, that differ only in the fee structure imposed to the investor. These different types are labeled as share classes and given that they correspond to the same underlying portfolio, they have highly correlated returns. 8

9 has been increasing on average over the years. Table 2 contains summary statistics of the family across years. As in the case of individual mutual funds, there is a steady increase in the number of fund families, yet slightly dropping over the recent years, consistent with family consolidations. Though, in contrast to the observed trend in the number of families, the average number of equity mutual funds per family has been monotonically increasing over time reaching 5 funds per family in Total net assets on the family level exhibit the same pattern as total assets on the fund level, hence indicating that the recent drop in value is due to the downturn in the financial markets. Other parameters such as expense ratios, fees and loads do not exhibit a substantial variation in time. 2.3 Measuring Fund Persistence In order to test our hypotheses we perform a series of tests based on the standard mutual fund persistence methodology 8.We restrict our attention to a sub-sample of funds that belong to families with a larger number of funds (or assets) under management, in order to test our hypothesis that funds belonging to larger families are more persistent. To measure abnormal returns, we use a four factor model. We use the Fama and French (1993) three-factor model augmented with a momentum factor similar to Jegadeesh and Titman (1993). This model has been shown in various contexts to provide explanatory power for the observed cross-sectional variation in fund performance. We therefore apply the following multi-factor model: r it = α i + b i MKT RF t + s i SMB t + h i HML t + p i MOM t + ɛ it t = 1, 2,..., T (1) where r it is the excess monthly return for fund i. MKTRF is the excess monthly return on the CRSP value-weighted stock index net of the one year Treasury-Bill. SMB and HML are the Fama-French (1993) factor mimicking portfolios for size and book to market. MOM, the momentum portfolio, is the equal-weighted average of firms with the highest 30 percent eleven-month returns lagged one month minus the equal-weighted average of firms with the 8 See for example Grinblatt, Titman, and Wermers (1997), Carhart (1997), and Wermers (2000) among others for a detailed description. 9

10 lowest 30 percent eleven-month returns lagged one month 9. At the beginning of every year, we form a sample of funds that belong to large families. A family is considered large if the number of funds it owns (or its market capitalization) exceeds a pre-specified threshold. Using prior twelve month returns, we regress each fund s monthly returns on the four factor model (equation 1) to obtain each fund s alpha over the prior year. Given this measure of performance we rank each fund by its alpha and assign the funds to one of 10 portfolios based on these rankings. The composition of these 10 ranksorted portfolios remains unchanged for the following 12 months. Following the sorting procedure, a value weighted return series is calculated for each portfolio. This process is repeated every year and results in 10 time series which are then regressed on the four factor model. A comparison of the alpha of the top portfolio (the portfolio of mutual funds that had the highest alphas the year prior to the ranking) with the alpha of the bottom portfolio (the portfolio of mutual funds that had the lowest alphas the year prior to the ranking) gives an indication of the persistence of mutual fund performance. To further test our hypothesis that large families choose selectively which of their funds to promote, we devise a second test that is a variation on the standard mutual fund persistence methodology. At the beginning of every year, after selecting those funds that belong to large families, we regress their prior twelve month returns on the four factor model (equation 1), thus obtaining each fund s alpha. Then, we rank each fund by its alpha inside its family and build 10 portfolios based on these rankings; this implies that for every family of at least 10 funds each of its funds is allocated to one of the 10 portfolios. One has to stress that contrary to the standard methodology, the result is not a portfolio of mutual funds ranked by their absolute performance, but a portfolio of funds ranked by their relative performance inside their respective families. We repeat this procedure for every year and consequently obtain 10 time series for the portfolios which are subsequently regressed on the four factor model. We then compare the alpha of the top portfolio (the portfolio of mutual funds that had the highest alpha within their family the previous year) with the alpha of the bottom portfolio (the portfolio of mutual funds that had the lowest alpha within their family the previous year). The statistical and economic significance of the difference of the alphas implies that funds exhibit persistence in their performance within their family. 9 We are grateful to Ken French for providing us with the SMB and HML factors, and to Mark Carhart for providing us with the MOM factor. 10

11 3 Empirical Results 3.1 Fund Persistence In table 3 we report the estimation results of the regression given in equation 1 for the 10 portfolios as outlined in section 2.3, while restricting ourselves to the sub-sample of funds that belong to large families, i.e. families with 10 funds or more 10. Since in this paper we take the viewpoint of the mutual fund family, we report our results using gross returns, however, the same results hold for net returns too. The same characteristics of multi-factor models regarding mutual fund performance reported in the literature also hold in our results. First, the R-squared are above 90% for almost all portfolios. Second, beta is significant at a 1% level for all portfolios, and so is the loading on SMB. The loading on HML is significant for most portfolios at the 1% significance level, except for portfolios 7 and 8. These are by now standard results outlined by Lehmann and Modest (1987) and many others, that a three factor model explains the main part of the return of mutual funds. Third, the momentum factor is only significant for portfolios 9 and 10, also a well documented result. One implication is that funds in portfolios with the highest alphas invest in momentum stocks, which funds in the lesser performing portfolios seem not to follow. However, beyond these standard results, the findings of our family oriented methodology differ from the standard results when analyzing the alphas of the portfolios. As can be seen in table 3, we find that the top portfolio has a positive monthly alpha of 35 basis points, and the bottom portfolio has a negative monthly alpha of -23 basis points. Thus, the portfolio that consists of longing the top portfolio and shorting the bottom portfolio (referred to as the 10-1 spread in all the tables) has a positive monthly alpha of 58 basis points (significant at a 1% level). The statistical significance becomes even more important when considering the economic significance of this difference, a monthly alpha of 58 basis points is equivalent to an annual abnormal return of 7.2%. In table 4 we give the analogous results using the full sample 11.The spread in alphas between deciles 1 and 10 is estimated at 35 basis points, and is statistically significant only at the 10 percent level. These results for persistence are relatively weak. The marginal statistical significance of the difference between winner and loser portfolios of funds has 10 An analysis of different definitions of large families is given in section These results are consistent with the standard results in the literature, such as Carhart (1997) and seem to be robust to the different time period used in this study. 11

12 lead the literature to conclude that there is no true managerial ability in actively managed mutual funds after accounting for the known risk factors in the market. Tables 3 and 4 are directly comparable. One notes immediately the larger difference in alphas between deciles 1 and 10 for the full sample which is estimated at 35 basis points per month with a t-stat of 1.75 compared to 58 basis points per month with a t-stat of This statistically significant difference of 23 basis points per month is the result we expected to see given our hypothesis in section 2.1, bigger families seem to be able to maintain a better persistence of their funds performance. The loadings on the factors are qualitatively similar when comparing the two tables, although the loadings on the momentum factor are higher in table 3, which implies that the winner funds in this sub-sample seem to hold more momentum stocks than the funds in the full sample. Since these results are quite different from the standard persistence results, we start by analyzing the 10 portfolios to see if they could provide us with some insight for these results. Table 5 Panel A reports the descriptive statistics of the 10 portfolios using the full sample and table 5 Panel B reports the descriptive statistics of the 10 portfolios using the subsample. As in the case of the regression results, we can make a direct comparison between the composition of the portfolios when considering the full sample and the sub-sample. The first thing one can notice is that the average and median fund in each rank of the sub-sample is consistently bigger than the average and median fund in the equivalent rank of the full sample. This observation is consistent with the results of Chen, Hong, Huang, and Kubik (2002) who show that even though fund size can adversely affect performance, family size may actually improve performance. Within each panel and across portfolios one can observe again the fact that the funds in the top and bottom portfolio are smaller than the funds in the other portfolios; again in accordance to the findings of Chen, Hong, Huang, and Kubik (2002). This is also consistent with the insight of Berk and Green (2002) who claim that performance should deteriorate with an increase in flow and a consecutive increase in fund size. The expense ratio and the loads don t vary much across portfolios, although the loads are higher in terms of mean and median than the loads on the whole sample. One might suspect that one reason for the better performance of the sub-sample might be the higher loads the funds charge, which deter investors from leaving or entering the fund and hence avoid in- or out-flows that have an adverse effect on fund performance (Edelen (1999)). To answer this, we calculate the average net flow in each portfolio and show that the mean 12

13 and median net flow of each portfolio doesn t differ significantly across the full sample and the sub-sample as reported in panels A and B of table 5. This is inconsistent with the idea that funds in the sub-sample that also charge higher fees should experience less flows than funds in the entire sample. Another possible alternative explanation to our results could be that the abnormal returns of the top portfolio could be due to higher spending on non observable resources 12 that contribute to the abnormal returns. Table 5 Panel B shows that the average expense ratio of all the portfolios are quiet similar. The top portfolio has an average expense ratio of while the average expense ratio of the bottom portfolio is In addition, our persistence results also hold when using net returns. The 10-1 spread portfolio has a positive alpha of 53 basis points, significant at a 1% level. This shows that our results are not driven by expenses. To see how long lived this fund persistence is, we perform the same methodology with a varying estimation time period. We conclude that the above described persistence holds only in the short term, observable at a one year horizon. With an estimation period of 2 years the 1-10 spread is reduced to 17 basis points per month.using a 3 years estimation period the statistical significance is lost. One alternative explanation to our results could be the presence of incubated mutual funds in our sample. By incubating funds for a short period, in effect the family builds up a considerable track record for its funds so that they show exceptional performance before being launched to the public 13. There are several reasons why, although appealing, this idea isn t applicable to our results. First, the number of incubated funds is not significant compared to the number of funds in our sample. Evans (2003) researches all the SEC filings for and finds only 60 such funds for the entire 9 years that were eventually launched. To put it in perspective, each of our portfolios includes every year on average more than 150 funds. Second, incubated funds have a very small size. Arteaga, Ciccotello, and Grant (1998) find their average size to be $5 million. In our sample, the average size of a fund in our top portfolio is $840 million which counters the notion of small funds entering the portfolios. Third, Arteaga, Ciccotello, and Grant (1998) and Wisen (2002) seem to conclude that incubation lasts one year. Since Evans (2003) finds that post incubation funds do not perform better than other funds, thus, it seems clear that our predictions 12 Resources such as higher investments in research or in more capable and expensive fund managers. 13 This tactic could allow the discontinuation of poor performing funds and thus capture only the positive side of the flow-performance relationship. 13

14 wouldn t be affected since in our methodology the presence of incubated funds would affect only the estimation period and not of the predictive period. According to our hypothesis, only families that have the ability to allocate resources will do so, and by using the number of funds as a proxy for this latitude we find persistence in fund performance. However, if we use the market capitalization of the family (although highly correlated with the number of funds in the family) we expect to get weaker results since even if it is a good proxy for the existence of resources we believe it is not that good a proxy for the family s latitude to allocate them in an unequal way between its funds. Market capitalization is a much cruder measure, since a family with one big fund has no latitude in allocating its resources compared to a family with 5 small funds. In table 6 we report the results of the same methodology but instead of using the number of funds as the proxy for family size we use the market capitalization of the family. We construct a sub-sample based on family size, where the threshold to family capitalization will yield the same sub-sample size as the prior analysis (that used the number of funds within the family), i.e. we use a threshold level such that the resulting sub-sample has the same number of funds as was generated by a threshold of 10 funds or more per family. The results in table 6 corroborate our hypothesis. The 10-1 spread is 35 monthly basis points statistically significant only at the 10% level, similar to the full sample. This result reinforces two claims. First, that it is not the amount of resources the family has, but the latitude to allocate them unevenly. And second, that it is not the mere statistical artifact of reducing the sample size that generates the results but indeed the selection criterion. 3.2 Ranking within the family As mentioned in section 2.1, given our hypothesis we not only expect to find an increased persistence in larger families but also that this persistence holds inside the family. Since the families have limited resources they are expected to favor certain funds over others. To test this, we thus perform a within analysis as detailed in section 2.3. Before analyzing these results it is important to stress the main difference between the two methods and their alternative interpretation. This analysis differs from what has been traditionally considered to be an analysis of persistence of mutual fund performance, since we do not look at the previous year s absolute best performers and ask if they persist at doing so. Instead, we ask whether, by taking into account information about the family of the fund ex-ante, one 14

15 can make some predictive statements about the performance of the fund ex-post. In table 7 we report the estimation results of these regressions. To be consistent with section 3.1 we use the same sub-sample and report the results for gross fund returns. Again the results hold also for net returns. The characteristics of the multi-factor model are similar to the one described in section 3.1. The loadings on the market, HML, SMB, and momentum are similar in pattern and magnitude. However, beyond these standard results, the findings of this within family methodology are quite interesting. As can be seen in table 7, we find that the top portfolio has a positive monthly alpha of 32 basis points, and the bottom portfolio has a negative monthly alpha of -21 basis points. Thus, the portfolio that consists of longing the top portfolio and shorting the bottom portfolio has a positive monthly alpha of 53 basis points (significant at a 1% level), equivalent to an annual abnormal return of 6.5%. These results are quite striking since they show that there is predictability of mutual fund performance based on the ranking of these funds relative to other funds inside their respective families. We believe that these predictability results are even more indicative of the fact that the family has an instrumental influence on the future performance of its funds than the results of section 3.1. If this were not the case then the 10-1 spread should have been much smaller than the one in table 3. This sorting criterion introduces some randomness into the portfolio ranking, since our methodology removes funds from the top portfolio that performed well on an absolute scale, yet were not the best performers in their families, and in return adds funds that didn t perform well on an absolute scale yet were the best performers in their family. Thus, it should have weakened the spread. The fact that it didn t, shows that the ranking criteria is indicative of an important phenomenon. In section 4 we perform several tests to try and corroborate this claim. 3.3 Robustness Tests We perform several robustness tests in order to check that indeed the results are a reflection of our hypotheses and not a statistical artifact Fund Size Table 5 Panel B includes an interesting result. There is a systematic pattern in the Mean Total Assets across all the portfolios. The funds in the top and bottom portfolio have a substantially lower average amount of assets under management than the funds in all other 15

16 portfolios. This result is not surprising, it is well documented that size and performance exhibit negative correlation. The only concern one can have while looking at these figures is whether there could be a way that our results are driven by fund size. In order to investigate this possibility, we perform the standard persistence methodology as described in section 3.1, where instead of sorting by alphas we sort by fund size (market capitalization). Using the same sub-sample and gross returns, at the beginning of every year, we rank each fund by its size and assign the funds to one of 10 portfolios based on these rankings. The composition of these 10 rank-sorted portfolios remains unchanged for the following 12 months. Following the sorting procedure a value weighted return series is calculated for each portfolio. This process is repeated every year and results in 10 time series which are then regressed on the four factor model. The results of this analysis are shown in table 8. None of the 10 portfolios has an alpha that is statistically different from zero, neither is the 10-1 spread portfolio. This shows that although our methodology generates portfolios that comprise of different size mutual funds, size is not the element driving the positive predictability results, but indeed it is the relative ranking inside the family Sample Size The criterion we use for keeping only funds that belong to families that have 10 or more funds reduces our sample to only 7% of all families, although in terms of funds it represents 38% of the full sample. Since the size of our sub-sample might be an issue, we apply the methodology for alternative sizes of the family, i.e. for various numbers of funds within the family, and obtain qualitatively similar results. When requiring that a fund belongs to a family of more than 5 mutual funds, our sample encompasses 22% of all the families, and 63% of all the funds of the full sample. As an illustration one can look at table 9 where we perform the same methodology for all the funds with 5 or more funds. As one can see the results are very similar. Our results also hold when using 5 instead of 10 portfolios. Interestingly, when using 5 portfolios the results of the within analysis gives better persistence results than the standard methodology. We attribute this fact to issues of power of our tests when performing the relative ranking procedure. 16

17 3.4 Fund Correlations Given our empirical findings so far, one might legitimately ask whether the observed persistence in funds within a family is due to the fact that some families are better than others. In other words, whether some families have better strategies which they employ in order to enhance the performance of their funds. If this indeed were the case, then one would expect to see a large correlation in returns of funds of the same family, as well as correlations of their abnormal returns (alphas), assuming that the family implements the same investment strategy in all funds. To test for that possibility, we calculate the average pairwise correlations of fund returns and abnormal returns within the same family. Correlations of fund returns are high, the average full sample correlation for gross (net) returns is 75.9% (75.8% respectively). This should not necessarily come as a surprise, since there is a lot of co-movement in fund returns generated by the common underlying factors (Market, SMB, HML, MOM). However, when we consider the correlations of the abnormal returns of the funds within one family, we get a different picture. The results are presented in table 10. Panel A provides characteristics of the distribution of average correlations of fund alphas within each family. The numbers are provided for the full sample of families, as well as for large and small families, i.e. for families with more (or respectively less) funds than a pre-specified cutoff. The numbers are quite revealing. The average pairwise correlation of fund alphas is 22.0% for the full sample. Yet, when we examine the correlations for the sub-samples, we note that within larger families, the correlations are substantially lower than within smaller families. The pairwise correlations of funds belonging to families with more than 10 funds have a mean of 13.1%, compared to a mean of 21.9% for the complementary sample of families with less than 10 funds. In addition, the distribution of average pairwise correlations has a higher standard deviation in the sample of smaller families than in larger families. This result is even more striking in Panel B, where the absolute value of the pairwise correlations of fund alphas within the same family is displayed. The average correlation of the full sample is 30.2%, and in accordance with Panel A, the sub-samples of small families has a much larger average pairwise correlation (30.6% for families with less than 10 funds) than the sub-sample of large families (14.1% for families with less than 10 funds). These results do not provide evidence that supports the idea that bigger families maintain a better persistence of performance by applying a common strategy to all their funds. 17

18 Instead, we actually note that there is a larger variation in investment styles within larger families 14. This fact points towards the hypothesis of a limitation of resources a family has, and implies that even if families have good investment ideas and strategies, these are not fully scalable and hence cannot be applied to the entire universe of funds within one family. Some selective allocation of these ideas has to occur. What we have claimed so far is that the choice where to allocate them depends on the effects of the performance-flow relationship and the implications thereof to aggregate inflows to the family. 4 The Role of the Family in Performance If a mutual fund family decides to promote some of its funds more than others, it will make sure that they exhibit an attractive performance record. One straightforward and observable way to accomplish this is by allocating human resources to those funds. Managers are one of the main resources families have both in actual terms and in the eyes of the investors. Therefore, it follows that asking whether the probability of adding another manager to a fund gives us an insight (and a good proxy) to an attempt from the family to push certain funds. If our hypothesis is wrong one would expect that after controlling for fund characteristics, there would no longer be any statistically significant difference in the probability of adding a manager between funds in different groups of performance ranking. In this section, we analyze this point. We hypothesize that a fund family promotes its best performing mutual funds by using its main resource, its managers, in a systematic and predictable way. We use a logistic regression framework to estimate the probability of a manager being added to a fund given that it is one of the best (respectively, one of the worst) performing funds within the family. 4.1 Data and Summary Statistics on Managers In order to test our hypothesis we use data on managers of the mutual funds that comprise our database. Our main source on manager data is the Morningstar Principia Pro s CDs (Morningstar), described in the data section Although one can obtain manager names at the fund level from CRSP, there exist some severe inaccuracies in the manager names 14 Our sample is comprised of funds that have an objective of Growth, Aggressive Growth, Growth and Income, Small Cap and Equity Income; hence the investment strategies considered here are not very different and therefore the sample of funds should not be that diversified. 18

19 as well as in the managing period. For instance, CRSP either misreports or leaves out manager names that are active in mutual funds, is not consistent in the documentation of the manager s name or is not consistent in the managing period, often observing a name of a manager dropping out and then reappearing after some time period. These drawbacks are quite severe and might affect adversely an analysis of managerial turnover. For these reasons we use Morningstar to obtain accurate information on the names of the managers for the funds of our sample. managers in our sample of 3,046 funds. During the period of we identify 4,150 different Table 11 provides some summary statistics of manager characteristics and their evolution over time. In panel A, one can note that the number of managers increases over time although it is clear that the bad market conditions of the past years had an impact in the evolution of the industry since this increase reverted in the last two years. Yet, contrary to the slight decline in the number of managers of actively managed equity mutual funds, the average number of funds under their control has been steadily increasing. This effect is probably purely mechanical and predominately driven by the faster reduction in the number of managers than in the number of mutual funds. The average size of the funds under management also increases over time, although it exhibits a decline in the last three years. Throughout their career, managers worked on average for 1.15 families. This is an indication of managerial turnover, as well as of consolidation within the mutual fund industry 15. In panel B, we look at the managers that manage more than one fund. As we noted earlier, 46% of the families are families of one equity fund 16 and therefore their managers can rarely (except for subcontracting with another fund) manage more than one fund. We can see that among those who manage more than one fund the number of funds has been steadily increasing over the years and has always averaged above 2.5 funds per manager. The descriptive statistics indicate that it is very prevalent to have more than one manager per mutual fund. In addition, managers are quite mobile since they switch between funds over time. 15 In a few cases, a merger or acquisition between two different mutual fund families results in the manager effectively changing managing company. In our sample, we treat this as a switch of family. 16 Viewed at the fund level, 11% of the funds in our sample are the only funds in their respective family. 19

20 4.2 The Probability of Adding a Manager In order to study the probability of adding a manager to a fund, we define a dichotomous dependent variable in a logistic regression framework. The variable equals one when there was at least one net managerial addition to the management team of a fund, and equals zero when no net additions were made to the team 17. This methodology is similar to Khorana (1996). Our main concern in this analysis is an issue of power. The low net managerial turnover has to be analyzed using 10 portfolios, resulting in an even further reduced managerial turnover by portfolio. If for consistency we were to perform our tests on 10 portfolios, there would be not enough managerial movements to get any statistical significance. To address this issue, we carry out all the logistic regressions using 5 portfolios instead. As we have mentioned in section 3.3.2, our results on fund persistence within the family hold also in a 5 portfolio framework, hence our hypothesis should also be testable in this case. To test our hypothesis, we run the following regression for each portfolio: P r t+1 (Adding a manager) = Λ [β 1 + β 2 α t + β 3 α t 1 + β 4 Log(T NA) t + β 5 Log(T NA) t 1 + β 6 Expense t ] (2) where Λ [ ] is the logistic cumulative distribution function. We estimate the specifications using maximum likelihood. α t is the alpha of the fund, estimated from the four factor model of equation 1. We account for the size of the fund by using the natural log of the total net assets (TNA). This should control for the situation where the fund s size increases and a new manager is needed due to the increased workload. We also account for the expenses of the fund in order to justify a situation where a manager is added in order to rationalize to investors the higher fees they are being charged 18. The results of the regression can be seen in table 12. The only portfolio where the alpha is significant is the top portfolio (portfolio 5). The coefficient is statistically significant at a 1% level. As we have hypothesized, the probability of adding a manager increases when a fund belongs to the top performing funds inside its family. Size is statistically significant for portfolios 3 and 4. The result is not surprising, since the largest funds are concentrated in the middle portfolios, hence they are be the ones 17 If the total number of managers in a team does not change even if there was managerial turnover, for example, if one manager was replaced by another one, we do not count this as a net addition. 18 We also performed these regressions including other combinations of controls such as, turnover, change in size and their lags. The main results were unchanged. 20

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