New Study Says Maybe Not
A longstanding controversy is whether professional investment managers are able to add value. Some older studies have suggested that, at least for mutual fund investors, actively managed funds consistently underperform index funds.
Now a study in the August 2000 issue of the Journal of Finance concludes that professional management does add value, but the added value is less than the costs associated with the funds. Wermers, Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transactions Costs, and Expenses, 55 J. Fin. 1655 (2000).
A preprint of the article is available at http://bus.colorado.edu/faculty/wermers/mutuals.pdf
Professor Wermers concludes in the preprint:
>>Our results over the 1975 to 1994 period indicate that mutual funds held stock portfolios that outperform a broad market index (the CRSP value-weighted index) by 1.3 percent per year. About 60 basis points is due to the higher average returns associated with the characteristics of stocks held by the funds, while the remaining 70 basis points is due to talents in picking stocks that beat their characteristic benchmark portfolios.
However, on a net-return level, the funds underperform broad market indexes by one percent per year. Of the 2.3 percent difference between the returns on stockholdings and the net returns of funds, 0.7 percent per year is due to the lower average returns of the non-stock holdings of the funds during the period (relative to stocks). The remaining 1.6 percent per year is split almost evenly between the expense ratios and the transactions costs of the funds. Thus, considering only their stockholdings, mutual fund managers hold stocks that beat the market portfolio by almost enough to cover their expenses and transactions costs, which is consistent with the equilibrium model of Grossman and Stiglitz (1980). Mutual fund holdings of cash and bonds, presumably to maintain liquidity in the face of uncertain investor inflows and redemptions, put a substantial drag on the net returns of funds relative to the market.
We also find that mutual fund trading has more than doubled from 1975 to 1994. However, even with the substantially higher level of trading, total transactions costs, in 1994, are about one-third their level in 1975. Our evidence also shows that high-turnover funds, while incurring substantially higher transactions costs and charging higher expenses, also hold stocks with much higher average returns than low-turnover funds. At least a portion of this higher return level is due to the better stock-picking skills of managers of high-turnover funds. Although these high-turnover funds have negative (but insignificant) characteristic-adjusted net returns, their average unadjusted net return over our sample period significantly beats that of the Vanguard Index 500 fund.
Copyright 2000, John M. Baker, Esq., Stradley, Ronon, Stevens & Young, LLP, 1220 19th Street, N.W., Suite 700, Washington, DC 20036 – (202) 822-9611- Fax (202) 822-0140 This article was originally posted to the FundLaw List, http://www.egroups.com/group/fundlaw. To subscribe to FundLaw, send a blank e-mail to firstname.lastname@example.org
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