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Chicago Booth BUSF 35150 - Mutual Funds

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17 Week 6 Mutual Funds17.1 Background1. It would be natural, and completely sensible, (and good marketing for MBA programs) iffunds outperform darts! Pros outperform in any other field.2. Except for... competition and free entry. The marginal fund will be worthless, and the averagefund may not be very good.3. The standard empirical approach and view (Jensen 1968):(a) There is a big bias problem, and this work is hard! (It’s more severe for hedge funds,venture capital funds)i. Survivor bias: Funds that close are not in database. Funds are more likely to closeif they have bad returnsii. Selection bias. Funds are more likely to report if they have good returns. (Or toreport audited returns)iii. Backfill bias. Often, when a fund is included in a database or index, all past historyof that fund is then included. This biases the results towards winners. Therewere other funds around during the backfill period that lost money and did not getincluded in the database.iv. Incubator bias. Fund families start “incubator funds,” and then only open the onesthat do well. They then report the entire history. It’s amazing that the SEC letsthem do this. This bias remains in the CRSP database.v. (My addition) Academic interest bias. We’re only interested in hedge funds sincethey did so well! All t statistics in the Journal of Finance are above 2.1.(b) You have to correct for beta. A fund which simply lev erages or holds higher beta stockswill seem to outperform with no skill. Thus, run CAPM regressions on funds and examinealphas.(c) √ again. Returns are so volatile, it’s very hard to measure mean returns.(d) After addressing all these problems, the standard result: The average fund underper-forms S&P by about 1%; typically even before fees.296−0.5 0 0.5 1 1.5−0.1−0.0500.050.10.15betaE(R)Notes: Average returns of mutual funds over the Treasury bill rate versus their(e) “Why the average fund?” y ou might object. Of course the average fund is bad — com-petition and easy entry into the fund business mean an yone will join. Why aren’t welooking at “the good funds?” What about Warren Buffet?(f) Answer: There is no way to tell after the fact if a given fund was lucky or skillful. Wemust look at average performance in a group; we have to look at some strategy we mightplausibly ha ve used for picking funds ahead of time, and then see what happens to allfunds w e migh t have picked.i. Just as with stocks, we sort all funds at  based on some indicator of “good,” thenwe watch those funds through the following year  +1. Wehavetomakesureweinclude all funds we w ould have picked at the time, and we have to make sure youkeep track of everyone including the losers and the dead in the following year.ii. Early answers: They looked (as in practice) at funds that had done well in previousyears. They found that there is a random w alk in funds too: Past winners are nomore likely to keep winning. Here “Good group” means past good performance.(g) What we can’t do: “why is Warren Buffet so good?” (Was he lucky? Where is ElmoBuffet?) “Sure average alpha is bad, but our track record is great.” (Why does ev eryonewho walks in the door have above average alpha?)(h) Whatwecando:Findeveryone who “looked like” Warren Buffet at ,investinthemthrough  + 1, track returns of winners and losers.4. More background(a) Most variation in ex-post fund returns is due to different strategies (small, large, value,growth, sector) etc. not to differences in particular stocks that funds pick (“style” not297“selection”). Quantitatively, suppose you run= + + 11+ 22+ ;  =1 2 for each (Here, we’re doing a style analysis or variance analysis, so the factors don’t have tobe “priced” factors. Even before smb and hml, people understood that stocks movedwhen their industries moved together. The CAPM just says that these betas don’t raiseexpected returns. ) Mutual funds hold quite diversified portfolios, so even individualfunds (not just portfolios of funds as in Carhart) have very high 2. More importantly,when you look at average returns in a sample, say 5 years, (E here means a 5 yearaverage)³´= +  ()+1³1´+ 2³2´then think about how () varies across mutual funds in that sample, you find almostall variation across funds in () comes from variation across funds in their  choicesand luck-of-the-draw in how the factors  that they load on happen to do, not fromvariation across funds in the alphas they achieve. (In 5 year samples, many “factors”suc h as industry that give no long-term average return and thus are not “priced” willnonetheless do well or poorly for 5 y ears.) Again, “most variation in results comes fromstyle not selection.”(b) Puzzles, to me:i. Why are there so many styles, and these are so unrelated to any betas or sensi-ble risks I’v e ever heard of? What does “gro wth and income” mean? Is this justmarketing, so we can always have some type of fund that did well last year to tout?ii. If value/size is important, why are w e arguing about performance relative to theMarket/CAPM? Why do value funds not blow away the graph? FF answer: Mostfunds were not really following value. (Davis, Fama, French, below; h breakpointsare -0.08 and 0.3 in my graph abov e). OK, but why not? (New facts, p.51) If fundsdidn’t know about the value premium, how can it be an equilibrium risk premium?(Their answer: “growth is where I can find alpha.”)iii. For 40 years we have been railing about the wasted money on active management.From Jensen 1968 to Ken French 2009. Yet it persists. Everywhere else, free marketeconomists say “if something pe rsists, it must be serving a function,” not “Activemanagement persists because investors are dumb.” We don’t allow the “investorsare dumb” story for price movements, how do we allow it for active management?iv. Put a different way, fees mean that active managemen t is valuable — people arepaying voluntarily. We just don’t know for what!v. Related, Carhart’s Table III shows that fees and turno ver are bad for investors.Why? This makes no sense from a market-at-equilibrium perspect ive. Managemen twants you to think more fees pay for more research, which raises alpha, and theysplit that

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