Characteristics Of Mutual Funds With Extreme Performance
Jason P. Berkowitz
St. John’s University – Department of Economics and Finance
Patrick J. Schorno
KPMG, USA
Dmitry Shapiro
University of North Carolina at Charlotte – The Belk College of Business Administration – Department of Economics
May 25, 2016
Abstract:
Our paper focuses on mutual fund characteristics associated with periods of extreme performance. We find funds with either positive (hot-hand) or negative (icy-hand) persistence tend to have portfolio similarities consistent with riskier positions: compared to no-streak funds they hold less stocks and invest more in top 10 holdings. Also both hot-hand and icy-hand funds have significantly higher turnover than benchmark funds.
At the same time, icy-hand (hot-hand) funds tend to have larger (smaller) management teams, and are less (more) likely to be managed by one manager. Finally, we do not observe many funds changing their management teams either before or after the streak of extreme performance. That is neither find we evidence that the beginning of extreme performance is associated with changes in management, nor that it causes changes in management.
Characteristics Of Mutual Funds With Extreme Performance – Introduction
Performance of mutual funds has continually been a focus for both investors and academic researchers. Starting with Jensen (1968), who documented negative average fund alphas net of expenses and trading costs, academic literature has accumulated a large body of evidence relating a funds’ performance to its characteristics. For instance, empirical evidence suggests that larger funds (Indro et al., 1999, Chen et al., 2004, Yan, 2008, and Ferreira et al., 2013) and funds with higher fees (Volkman and Wohar, 1995, Carhart, 1997, Prather et al., 2004, and Gil-Bazo and Ruiz-Verdu, 2009) perform worse. Additionally, there is evidence of short-term persistence in fund performance (Hendricks et al., 1993 and Huij and Verbeek, 2007) and also a “smart money” effect (Gruber, 1996 and Sapp and Tiwari, 2007).
The focus of this paper is on the characteristics of mutual funds that experienced continuous periods of either extremely good or extremely bad performance. Following the terminology of Gilovich et al. (1985), we refer to a period of continuous extreme positive performance as a hot-hand streak and a period of continuous extreme negative performance as an icy-hand streak. We are interested in two groups of questions. First, whether funds with hot-hand or icy-hand streaks differ before, during, or after their streaks from funds that do not experience extreme performance. Second, whether characteristics differ between funds with positive extreme performance and funds with negative extreme performance.
Using data from Morningstar Principia, we form a panel data set consisting of 10,898 ‘growth’ and ‘growth and income’ funds world-wide from the first quarter of 1999 through the third quarter of 2011. We say that a fund had a streak of extreme positive (negative) performance if the fund had quarterly returns in the top (bottom) 10% for at least four consecutive quarters. Funds with extreme performance are then compared to two benchmarks: (1) all funds without extreme performance; and, (2) funds that are matched with extreme performance funds using propensity score matching.
Our results are as follows. First, we show that there are common factors in how hot-hand funds and icy-hand funds differ from both the propensity score matched benchmark funds and all other funds. Both hot-hand and icy-hand funds have higher turnover and they hold riskier portfolios than benchmark funds. The latter result manifests itself in that funds with extreme performance have portfolios that are (a) less diversified, and (b) have higher beta than the benchmark. As properly diversified portfolios are unlikely to exhibit extreme returns, it is intuitive that both negative and positive extreme performance comes from under-diversified portfolios. However, the characteristics of icy-hand funds tend to be more extreme than hot-hand funds. For example, funds during the icy-hand streak have, on average, as much as 65.88% of their portfolio invested in their top ten holdings. For hot-hand funds, this number is 41.53% and for the funds without extreme performance it is 38.3%. Similarly, the portfolio turnover during an icy-hand streak reaches 284.9, which is much higher than the portfolio turnover of 196.8 during a hot-hand streak, or the portfolio turnover of 92.4 of funds without extreme performance.
Next, we look at which characteristics are responsible for triggering the beginning and the end of the extreme performance period. Decreases in the total number of holdings and the expense ratio have a significant effect on the probability of the hot-hand starting. As for the icy-hand funds, an increase in both the total number of holdings and the turnover has a significant effect. These results highlight that positive and negative performance funds take different paths towards their streaks of extreme performance.
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