A Review Of Behavioral And Management Effects In Mutual Fund Performance

Keith Cuthbertson

City University London – Sir John Cass Business School

Dirk Nitzsche

City University London – Sir John Cass Business School

Niall O’Sullivan

University College Cork – Department of Economics

January 28, 2016

Forthcoming, International Review of Financial Analysis


This paper surveys and critically evaluates the literature on the role of management effects and fund characteristics in mutual fund performance. First, a brief overview of performance measures is provided. Second, empirical findings on the predictive power of fund characteristics in explaining future returns are discussed. Third, the paper reviews the literature on fund manager behavioral biases and the impact these have on risk taking and returns. Finally, the impact of organizational structure, governance and strategy on both fund risk taking and future performance is examined. While a number of surveys on mutual fund performance are available, these have not focused on the role of manager behavioral biases, manager characteristics and fund management strategic behavior on fund performance and risk taking. This review is an attempt to fill this gap. Empirical results indicate that finding successful funds ex-ante is extremely difficult, if not impossible. In contrast, there is strong evidence that poor performance persists for many of the prior “loser fractile” portfolios of funds. A number of manager behavioral biases are prevalent in the mutual fund industry and they generally detract from returns.

A Review Of Behavioral And Management Effects In Mutual Fund Performance – Introduction

Mutual funds are pooled investments which provide liquidity and enable investors to enjoy economies of scale from low cost diversified portfolios which are often differentiated by fund styles such as aggressive growth, growth and income, growth, equity-income and small companies1. Most funds are ‘active’ in that they either try to pick ‘winner stocks’ or they engage in market timing (i.e. predicting relative returns of broad asset classes) and these managed funds generally charge higher fees than ‘index’ or ‘tracker’ funds (which mimic movements in broad market indexes)2. In the US and UK about 70% of institutional funds are actively managed and this rises to over 90% for retail funds.

As of 2014, total worldwide assets invested in mutual funds and exchange-traded funds was $33.4 trillion. US mutual fund total net assets was almost $16tn (Europe was $9.5tn, UK was $1.2tn) and 52% of this total was invested in equity (domestic and global). In the US, 53m households (43% of households, and 90m individuals) own mutual funds3. This extensive ownership of, and exposure to, mutual funds gives rise to considerable interest in mutual fund performance, not least in the academic literature.

The rationale for managed funds is that they “add value” by using private information and manager skill to produce “abnormal performance”. Future fund performance may be influenced by fund characteristics (e.g. past performance, turnover, age of the fund, fees, fund flows, tracking error), compensation structures (e.g. incentive payments, extent of managerial ownership of the funds), fund manager characteristics (e.g. educational attainment, managerial tenure) and strategic considerations (e.g. manager change, board composition, mergers and acquisitions).

The extant literature around mutual fund performance may be classified as follows. First, there is a large volume of work focused on performance evaluation of funds including performance persistence, market timing and volatility timing.

Second, cross-sectional evidence on the relation between fund performance and fund characteristics has also received attention. In particular, recent studies have examined the impact on fund performance of fund attributes such as fund flow, active share, industrial concentration, fund size, industry size, turnover, commonality in stock holdings, manager compensation structures, competitive pressures and discretionary versus liquidity trading.

Third, is the impact of behavioral effects on fund performance and manager risk taking. Behavioral finance recognizes that investor psychological biases often lead to practices that deviate from those predicted by rational models. Key manager behavioural patterns include excessive trading, overconfidence, a disposition effect, herding, window dressing, risk taking and home bias – while behavior patterns also arise due to career concerns (e.g. employment risk), fund ownership structure and performance related incentive fees.

Finally, the mutual fund literature looks at the impact on performance of fund management company (FMC) governance and culture, organizational structure and strategy. Organizational structure can bestow benefits on funds. For example, being part of a fund family allows funds to enjoy economies of scale in advertising, and also allows FMCs to strategically shift investment opportunities (e.g. IPOs) or risk, between funds. Further governance, structure and strategy topics that arise in the literature include fiduciary responsibility and stewardship, corporate culture, fund families, mergers and acquisitions, affiliated funds of funds and fund incubation. We review this literature and its impact on fund performance and risk taking.

Mutual Fund Performance Evaluation

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