Market Frictions, Investor Sophistication and Persistence in Mutual Fund Performance Ariadna Dumitrescu 1 Javier Gil-Bazo 2 1 Department of Finance ESADE Business School 2 Department of Economics and Business University Pompeu Fabra and Barcelona GSE UC3M, March 31, 2014
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Market frictions, Investor sophistication and persistence in mutual fund performance
We develop a BG-type model (an active manager competes against a passive investment) with investors characterized by frictions: search costs and financial constraints
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Market Frictions, Investor Sophistication andPersistence in Mutual Fund Performance
Ariadna Dumitrescu1 Javier Gil-Bazo2
1Department of FinanceESADE Business School
2Department of Economics and BusinessUniversity Pompeu Fabra and Barcelona GSE
UC3M, March 31, 2014
Motivation
“Our system of investor protection is predicated on the notion thatinvestors who are armed with complete and accurate information willbe able to look out for their own interests. This concept may be overlyoptimistic in its assumptions about the financial sophistication ofaverage retail investors.” (Barbara Roper, Consumer Federation ofAmerica)
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 2 / 34
Motivation
Investor protection focused on information disclosure
Too optimistic about retail investors’ financial sophistication:
Biases (e.g., Barber and Odean, 2000; Bailey, Kumar, and Ng,2011)Financial illiteracy (e.g., Lusardi and Tufano, 2009; van Rooij et al.2011)Frictions: search costs, switching costs, information processingcosts (Hortaçsu and Syverson, 2004; Brunnermeier and Oehmke,2009)Some investors more sophisticated than others
This paper: Consequences of frictions for equilibrium in themutual fund market.
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 3 / 34
Berk and Green (2004)
Berk and Green (BG) (2004): If investors compete for the best mutual fundsin a friction-less market with increasing marginal trading costs, all fundsshould deliver zero net expected risk-adjusted return in equilibrium
Empirical evidence favorable to diseconomies of scale hypothesis (Chen etal., 2004; Yan et al., 2008; Turtle and Wang, 2013)
...but not to BG’s model implications:
Average fund earns negative net alpha (e.g., Jensen, 1968; Gruber,1996; Wermers, 2000)
Underperformers persist (Carhart, 1997) and some evidence ofshort-term persistence in outperformance (Bollen and Busse, 2004)
Performance predictable from fees and trading costs (e.g., Gil-Bazo andRuiz-Verdu, 2009; Edelen, Evans & Kadlec, 2007)
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 4 / 34
Berk and Green (2004)
Berk and Green (BG) (2004): If investors compete for the best mutual fundsin a friction-less market with increasing marginal trading costs, all fundsshould deliver zero net expected risk-adjusted return in equilibrium
Empirical evidence favorable to diseconomies of scale hypothesis (Chen etal., 2004; Yan et al., 2008; Turtle and Wang, 2013)
...but not to BG’s model implications:
Average fund earns negative net alpha (e.g., Jensen, 1968; Gruber,1996; Wermers, 2000)
Underperformers persist (Carhart, 1997) and some evidence ofshort-term persistence in outperformance (Bollen and Busse, 2004)
Performance predictable from fees and trading costs (e.g., Gil-Bazo andRuiz-Verdu, 2009; Edelen, Evans & Kadlec, 2007)
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 4 / 34
Berk and Green (2004)
Berk and Green (BG) (2004): If investors compete for the best mutual fundsin a friction-less market with increasing marginal trading costs, all fundsshould deliver zero net expected risk-adjusted return in equilibrium
Empirical evidence favorable to diseconomies of scale hypothesis (Chen etal., 2004; Yan et al., 2008; Turtle and Wang, 2013)
...but not to BG’s model implications:
Average fund earns negative net alpha (e.g., Jensen, 1968; Gruber,1996; Wermers, 2000)
Underperformers persist (Carhart, 1997) and some evidence ofshort-term persistence in outperformance (Bollen and Busse, 2004)
Performance predictable from fees and trading costs (e.g., Gil-Bazo andRuiz-Verdu, 2009; Edelen, Evans & Kadlec, 2007)
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 4 / 34
Berk and Green (2004)
Possible explanations:
No diseconomies of scale: Reuter and Zitzewitz (2013)
Investor irrationality: What type of irrationality? How does it impactfund performance?
Frictions
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 5 / 34
Berk and Green (2004)
Possible explanations:
No diseconomies of scale: Reuter and Zitzewitz (2013)
Investor irrationality: What type of irrationality? How does it impactfund performance?
Frictions
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 5 / 34
Berk and Green (2004)
Possible explanations:
No diseconomies of scale: Reuter and Zitzewitz (2013)
Investor irrationality: What type of irrationality? How does it impactfund performance?
Frictions
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 5 / 34
What we do
We develop a BG-type model (an active manager competes against apassive investment) with investors characterized by frictions: search costsand financial constraints
Findings:
Negative expected (net) performance in equilibrium
Expected performance increasing in expected managerial skill⇒ Persistence
New prediction: Persistence more prevalent among more visible funds (higherfraction of unsophisticated investors)
We then test the model’s new prediction with the data
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 6 / 34
What we do
We develop a BG-type model (an active manager competes against apassive investment) with investors characterized by frictions: search costsand financial constraints
Findings:
Negative expected (net) performance in equilibrium
Expected performance increasing in expected managerial skill⇒ Persistence
New prediction: Persistence more prevalent among more visible funds (higherfraction of unsophisticated investors)
We then test the model’s new prediction with the data
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 6 / 34
Related literature
Studies on conditional persistence:
Berk and Tonks (2007): Past fund performance affects investor composition:performance more persistent after poor returns
Glode et al. (2009): Past market performance affects investor composition:performance more persistent after high market returns
Elton, Gruber and Blake (2011): Persistence does not depend on fund size
Ferreira et al. (2010): Increasing returns to scale and competition amongfunds (both at the country level) are associated with less persistence.
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 7 / 34
The model
Model retains BG’s main features: rationality and diseconomies of scale
Frictions:
Search costs: Each investor i has a specific search cost γi that reflectsher ability to find an alternative investment: an index fund with zeroperformance
i-th investor’s reservation return = −γi
Financial constraints: Investor i endowed with m dollars and subject toa liquidity shock with probability γi , expected investment = m (1− γi ) .
We also consider an entry cost, K , borne by new investors
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 8 / 34
Timeline
Investors
enter the fund
t − 1
Fund’s return at date t is realized
Current Investors decide whether to re-invest or not
New Investors decide whether to invest and pay entry cost K
t
Fund return at date
t + 1 is realized
t + 1
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 9 / 34
The model
0 γSup
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 10 / 34
The model
0 γMAX γSup
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 11 / 34
The model
0 γ γMAX γSup
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 12 / 34
The model: Equilibrium
Equilibrium: an amount of assets q∗t+1 and the associated expected
risk-adjusted net return, TPt+1(q∗
t+1)
= φt+1 −C(q∗
t+1)
q∗t+1
− f , such that:
All current investors that (re)invest in the fund have reservationreturns lower than TPt+1
(q∗
t+1)
All new investors that invest in the fund have reservation returnslower than TPt+1
(q∗
t+1)− K
Holding f constant, depending on φt+1: (i) nobody invests; (ii) somecurrent investors reinvest; (iii) all current but no new investors invest;(iv) new investors invest; (v) all target investors invest
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 13 / 34
The model: Equilibrium
0 γ γ∗ γMAX γSup
γ∗ = γC obtained from TPt+1(qC
t+1
)= −γC
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 14 / 34
The model: Equilibrium
0 γ∗ γ γMAX γSup
γ∗ = γN obtained from TPt+1(qN
t+1)− K = −γN
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 15 / 34
Proposition 1: Expected net performance
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 16 / 34
Proposition 2: Comparative statics, K = 0
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 17 / 34
Proposition 2: Comparative statics, K > 0
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 18 / 34
Endogenous Fee
When the manager chooses f to maximize fq∗t+1(f ):
f increases with φ,
however, f increases less that one-to-one with φ, so TP stillincreasing in phi ,
except when there is no entry of investors
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 19 / 34
Endogenous Fee
When the manager chooses f to maximize fq∗t+1(f ):
f increases with φ,
however, f increases less that one-to-one with φ, so TP stillincreasing in phi ,
except when there is no entry of investors
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 19 / 34
Endogenous Fee
When the manager chooses f to maximize fq∗t+1(f ):
f increases with φ,
however, f increases less that one-to-one with φ, so TP stillincreasing in phi ,
except when there is no entry of investors
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 19 / 34
Testing the Model
Difficult to base our test on investor sophistication
Instead, test the prediction that performance of high-visibility fundsmore sensitive to managerial skill
Since managerial skill persistent (by definition?), performance ofhigh-visibility funds should persist longer
Unexpected result!
Test: regress future performance on past performance, comparecoefficient between high- and low-visibility funds
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 20 / 34
Testing the Model
Difficult to base our test on investor sophistication
Instead, test the prediction that performance of high-visibility fundsmore sensitive to managerial skill
Since managerial skill persistent (by definition?), performance ofhigh-visibility funds should persist longer
Unexpected result!
Test: regress future performance on past performance, comparecoefficient between high- and low-visibility funds
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 20 / 34
Testing the Model
Difficult to base our test on investor sophistication
Instead, test the prediction that performance of high-visibility fundsmore sensitive to managerial skill
Since managerial skill persistent (by definition?), performance ofhigh-visibility funds
should persist longer
Unexpected result!
Test: regress future performance on past performance, comparecoefficient between high- and low-visibility funds
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 20 / 34
Testing the Model
Difficult to base our test on investor sophistication
Instead, test the prediction that performance of high-visibility fundsmore sensitive to managerial skill
Since managerial skill persistent (by definition?), performance ofhigh-visibility funds should persist longer
Unexpected result!
Test: regress future performance on past performance, comparecoefficient between high- and low-visibility funds
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 20 / 34
Testing the Model
Difficult to base our test on investor sophistication
Instead, test the prediction that performance of high-visibility fundsmore sensitive to managerial skill
Since managerial skill persistent (by definition?), performance ofhigh-visibility funds should persist longer
Unexpected result!
Test: regress future performance on past performance, comparecoefficient between high- and low-visibility funds
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 20 / 34
Empirical Strategy
We construct a panel of monthly risk-adjusted portfolio alphas using Carhart’s(1997) model:
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 28 / 34
Performance persistence among winners and losers
To distinguish between persistence in poor and good performance, weestimate:
α̂i,t :t+11 = δ0,t +∑
n
δ1,ndec_ni,t−1
+∑
n
δ2,ndec_ni,t−1LOi,t−1 +∑
n
δ3,ndec_ni,t−1HIi,t−1
+δ4LOi,t−1 + δ5HIi,t−1 + ∆X ′i,t−1 + ξi,t :t+11,
where dec_ni,t−1 = 1 if fund i ’s past performance in n − th decile(1st=bottom, 10th=top)
We consider n = 1,2,3,8,9,10
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 29 / 34
Performance persistence among winners and losers
#Inv Cat Family Size Family Age Family Adv.dec_1(α)(bottom) -0.008*** -0.012*** -0.010*** -0.009*** -0.009*dec_2(α) -0.004*** -0.005*** -0.003* -0.005** -0.006*dec_3(α) -0.003*** -0.003*** -0.003** -0.003*** -0.001dec_8(α) 0.003*** 0.003** 0.003** 0.003** 0.001dec_9(α) 0.006*** 0.006*** 0.008*** 0.007*** 0.008***dec_10(α)(top) 0.010*** 0.014*** 0.015*** 0.014*** 0.020***dec_1(α) x LO 0.012** 0.010** 0.009* 0.000dec_2(α) x LO 0.003 -0.000 0.002 0.003dec_3(α) x LO 0.006*** 0.003 0.007** -0.001dec_1(α) x HI 0.006 -0.003 -0.001 0.017**dec_2(α) x HI 0.002 -0.003 0.001 -0.002dec_3(α) x HI -0.001 -0.001 -0.001 -0.003dec_8(α) x LO -0.004* -0.004* -0.004 0.001dec_9(α) x LO -0.001 -0.004 -0.004 -0.003dec_10(α) x LO -0.016*** -0.014*** -0.011** -0.013**dec_8(α) x HI 0.003 0.001 0.002 0.011**dec_9(α) x HI 0.003 -0.004 -0.000 0.004dec_10(α) x HI -0.005 -0.008 -0.007 -0.001LO 0.004* 0.008*** -0.002 -0.003*HI -0.000 -0.002 -0.001 -0.002Time Fixed Effects Yes Yes Yes Yes YesControls Yes Yes Yes Yes YesObservations 108,524 108,524 108,524 108,524 101,098Adjusted R-squared 0.076 0.077 0.078 0.077 0.079
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 30 / 34
Ranking on returns
#Inv Cat Family Size Family Age Family Adv.dec_1(ret)(bottom) -0.009*** -0.013*** -0.012*** -0.012*** -0.009dec_2(ret) -0.004*** -0.006*** -0.007*** -0.004** -0.004dec_3(ret) -0.003** -0.004** -0.003** -0.003* 0.000dec_8(ret) 0.000 -0.000 -0.001 0.001 0.002dec_9(ret) 0.002 0.001 0.002 0.003 0.007*dec_10(ret)(top) 0.003 0.003 0.003 0.005 0.006dec_1(ret) x LO 0.012*** 0.010** 0.012*** -0.001dec_2(ret) x LO 0.009*** 0.008** 0.005* -0.000dec_3(ret) x LO 0.005 0.003 0.005* -0.003dec_1(ret) x HI 0.011** 0.001 0.003 -0.002dec_2(ret) x HI 0.003 0.003 -0.004 -0.001dec_3(ret) x HI 0.002 0.001 -0.003 -0.001dec_8(ret) x LO 0.000 0.002 -0.001 -0.002dec_9(ret) x LO 0.000 0.002 -0.003 -0.006dec_10(ret) x LO -0.002 0.001 -0.002 -0.004dec_8(ret) x HI 0.002 0.002 -0.003 -0.003dec_9(ret) x HI 0.002 -0.004 -0.003 -0.004dec_10(ret) x HI 0.002 -0.003 -0.004 -0.000LO 0.001 0.004 -0.003 -0.003HI -0.001 -0.004* 0.000 0.001Time Fixed Effects Yes Yes Yes Yes YesControls Yes Yes Yes Yes YesObservations 108,524 108,524 108,524 108,524 101,098Adjusted R-squared 0.073 0.074 0.074 0.074 0.075
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 31 / 34
Retail funds only
#Inv Cat Family Size Family Age Family Adv.dec_1(α)(bottom) -0.011*** -0.012*** -0.017*** -0.012** -0.009dec_2(α) -0.006*** -0.007*** -0.006** -0.008*** -0.008dec_3(α) -0.003** -0.004** -0.003* -0.005** -0.000dec_8(α) 0.003** 0.005** 0.004 0.004** -0.002dec_9(α) 0.006*** 0.005* 0.007** 0.007*** 0.004dec_10(α)(top) 0.010*** 0.012** 0.015*** 0.012*** 0.018**dec_1(α) x LO 0.013** 0.017*** 0.015* -0.001dec_2(α) x LO 0.004 0.001 0.008* 0.004dec_3(α) x LO 0.006** 0.002 0.008* -0.002dec_1(α) x HI -0.015* 0.002 -0.007 -0.003dec_2(α) x HI -0.004 -0.004 0.002 -0.014dec_3(α) x HI -0.002 -0.001 0.001 -0.005dec_8(α) x LO -0.005* -0.005 -0.003 0.005dec_9(α) x LO 0.001 -0.002 -0.003 0.001dec_10(α) x LO -0.013** -0.014** -0.008 -0.010dec_8(α) x HI -0.000 0.002 -0.001 0.018***dec_9(α) x HI 0.002 -0.003 -0.001 0.008dec_10(α) x HI 0.007 -0.003 -0.004 0.014LO 0.006** 0.005 -0.001 -0.000HI 0.001 -0.001 0.006** -0.002Time Fixed Effects Yes Yes Yes Yes YesControls Yes Yes Yes Yes YesObservations 55,214 55,214 55,214 55,214 48,643Adjusted R-squared 0.068 0.071 0.070 0.070 0.069
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 32 / 34
Conclusions
Interaction of market frictions can generate both negative and positiveexpected performance in equilibrium as well as cross-sectionaldifferences in performance
Less visible funds exhibit a substantially lower degree of persistence inperformance
However, more visible funds’ performance does not persist more
Institutional investors not necessarily more sophisticated (James andKarceski, 2006; Phillips et al., 2012))
More information disclosure should be accompanied by policies: (i)aimed at reducing participation costs and (2) especially targeted to theleast sophisticated investors
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 33 / 34
Conclusions
Interaction of market frictions can generate both negative and positiveexpected performance in equilibrium as well as cross-sectionaldifferences in performance
Less visible funds exhibit a substantially lower degree of persistence inperformance
However, more visible funds’ performance does not persist more
Institutional investors not necessarily more sophisticated (James andKarceski, 2006; Phillips et al., 2012))
More information disclosure should be accompanied by policies: (i)aimed at reducing participation costs and (2) especially targeted to theleast sophisticated investors
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 33 / 34
Conclusions
Interaction of market frictions can generate both negative and positiveexpected performance in equilibrium as well as cross-sectionaldifferences in performance
Less visible funds exhibit a substantially lower degree of persistence inperformance
However, more visible funds’ performance does not persist more
Institutional investors not necessarily more sophisticated (James andKarceski, 2006; Phillips et al., 2012))
More information disclosure should be accompanied by policies: (i)aimed at reducing participation costs and (2) especially targeted to theleast sophisticated investors
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 33 / 34
Conclusions
Interaction of market frictions can generate both negative and positiveexpected performance in equilibrium as well as cross-sectionaldifferences in performance
Less visible funds exhibit a substantially lower degree of persistence inperformance
However, more visible funds’ performance does not persist more
Institutional investors not necessarily more sophisticated (James andKarceski, 2006; Phillips et al., 2012))
More information disclosure should be accompanied by policies: (i)aimed at reducing participation costs and (2) especially targeted to theleast sophisticated investors
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 33 / 34
Conclusions
Interaction of market frictions can generate both negative and positiveexpected performance in equilibrium as well as cross-sectionaldifferences in performance
Less visible funds exhibit a substantially lower degree of persistence inperformance
However, more visible funds’ performance does not persist more
Institutional investors not necessarily more sophisticated (James andKarceski, 2006; Phillips et al., 2012))
More information disclosure should be accompanied by policies: (i)aimed at reducing participation costs and (2) especially targeted to theleast sophisticated investors
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 33 / 34
To-do list
Competition among two active funds: Cournot-type duopoly
Exogenous source of variation in visibility:
“Star” in the familyNon-performance related news about family/fundMerger into a larger fund/family
Any ideas?
Dumitrescu & Gil-Bazo Persistence in Mutual Fund Performance 34 / 34