4-3.2 International Evidence on Active Mutual Fund Management

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From the course by University of Illinois at Urbana-Champaign

Investments II: Lessons and Applications for Investors

209 ratings

University of Illinois at Urbana-Champaign

Investments II: Lessons and Applications for Investors

209 ratings

Course 4 of 7 in the Specialization Financial Management

In this course, you will start by reviewing the fundamentals of investments, including the trading off of return and risk when forming a portfolio, asset pricing models such as the Capital Asset Pricing Model (CAPM) and the 3-Factor Model, and the efficient market hypothesis. You will be introduced to the two components of stock returns – dividends and capital gains – and will learn how each are taxed and the incentives provided to investors from a realization-based capital gains tax. You will examine the investment decisions (and behavioral biases) of participants in defined-contribution (DC) pension plans like 401(k) plans in the U.S. and will learn about the evidence regarding the performance of individual investors in their stock portfolios. The course concludes by discussing the evidence regarding the performance of actively-managed mutual funds. You will learn about the fees charged to investors by mutual funds and the evidence regarding the relation between fees charged and fund performance. Segments of the portfolios of mutual funds that may be more likely to outperform and examples of strategies designed to “earn alpha” will also be introduced. Learners are welcome to take this course even if they have not completed "Investments I: Fundamentals of Performance Evaluation," as the first module contain a review of investment fundamentals and regression analysis to get everyone up to speed. Also, the course contains several innovative features, including creative out-of-the-studio introductions followed by quick-hitting "Module in 60" countdowns that highlight what will be covered in each module, four "Faculty Focus" interview episodes with leading professors in finance, and a summary of each module done with the help of animations! This course is part of the iMBA offered by the University of Illinois, a flexible, fully-accredited online MBA at an incredibly competitive price. For more information, please see the Resource page in this course and onlinemba.illinois.edu.

From the lesson

Module 4: Performance of Mutual Funds and Search for Alpha

In Module 4, we will learn about the evidence regarding the performance of actively-managed mutual funds. We will also discuss a few examples of portfolio strategies designed to “earn alpha” (i.e., yield positive risk-adjusted returns).

4-3.1 Economics of Mutual Funds28:34

4-3.2 International Evidence on Active Mutual Fund Management15:20

Meet the Instructors

Scott Weisbenner
William G. Karnes Professor of Finance
Department of Finance, College of Business

[MUSIC]

So now we're going to look at Mutual Funds and kind of just broaden the scope.

Coursera, one of the great things is the international perspective

that the students bring to the course.

So why don't we provide an international perspective here looking at mutual funds?

So one of the things when you design the course,

you have to find these kind of images that are available for reuse, so

what do I want to find international perspective?

Just a globe with random bars, and random numbers in the background.

Sorry Coursera, this is kind of the best I can do to get you to motivate this video.

But, what are the questions they're going to look at?

What are mutual funds like around the world?

So what do we mean by what are they like?

Well, let's look at a breakdown of mutual funds across countries.

Those explicit index funds, closet index funds, or they're actively managed funds,

but they seem like they're following indexes pretty closely,

and then actively managed funds.

What's the breakdown of mutual funds across countries, and we're focusing

on kind of looking at equity stock funds, when doing this breakdown.

And then also, how do investor cost fees vary across these three

types of mutual funds across the different countries.

So what is the typical index fund fee in the US versus Germany or

Switzerland or Poland, and how to actively manage funds vary across countries.

Do some countries have more closet index funds, which you generally want to avoid?

Why pay an active management fee for

a mutual fund that's investing like an index fund.

So it's interesting to see what countries have more closet index funds,

which have less.

So let's kind of end our lectures here

by doing this kind of fascinating international comparison, okay?

And we're going to look at the results of a recently published paper, Cremers,

Ferreira, Matos, and Starks, they studied characteristics of passively and

actively managed equity funds across a wide sample of 22

regions/countries over the period 2002 to 2010.

Now, the results i'm going to show you are the results based on December, 2010 data.

So pretty recent stuff here.

So in this, we need to do a definition.

The authors need to come up with a definition.

How do you define closet index funds?

So they use this active share following kind of research in the mutual

fund literature.

What is this active share to kind of measure?

Is this mutual fund a closet indexer or not?

When you look at this active share, you're going to look at what is the index

that this mutual fund is following, okay?

Then look at what are all the weights of the fund

across all the stocks, compare that to the benchmark weight.

So for example, what weight does a fund have

in Coca-Cola relative to the benchmark weight in Coca-Cola?

What weight does a fund have in GE relative to the benchmark weight in GE?

And look at these differences in fund weight, and

benchmark weight across all the stocks.

And once you take the kind of summing up

all these absolute deviations of the fund weight from the benchmark weight,

take that total, divide it by two, that's the active share, okay?

So let's give a few examples with this here.

So look at this active share,

let's assume that the fund is perfectly mimicking the index fund.

So in that case, the weight of the fund in Coca-Cola is going to exactly

equal the weight of the index in Coca-Cola.

So that difference will be zero,

that difference will be zero across all the stocks.

So the active share when we add it up is going to equal zero.

Okay, what if on the other hand, the mutual fund is investing in totally

different stocks than the index fund, it's supposed to be mimicking, okay?

Or supposed to be following as a benchmark.

So, the mutual fund investing in totally different stocks than its benchmark fund.

Okay, what do we expect then?

Well, when we add this up across all the stocks,

we should expect this to sum up to 200 divided by 2 would be 100.

So an active share of 100.

The mutual funds investing in totally different stocks then it's benchmarked,

it's a 100% different from the benchmarks when active share would be

a 100 in that case, okay?

It's summed up again over all the stocks, active share for mutual fund will be zero.

If it has identical portfolio weights to the benchmark, as we just discussed,

and it will be 100% if there's no overlap at all with the benchmark.

So think if it can vary between 0 and 100%, 0 is perfect closet indexing.

100% is there's no overlap with the benchmark, so very active.

Okay, so what do Cremer, Ferreira, Matos and Starks,

how did they classify an actively managed fund as a closet index?

Or will they look at does this active share, is it below 60%?

If the answer is yes, then we call it a closet index.

So this is their definition, they're the ones that designed all the figures so

let's go go with this, okay.

So another way to think about this is, these funds have more than a 40%

overlap of fund portfolio weights, with their benchmark portfolio weights.

It'd kind of be the flip side, okay.

Remember, actively-managed funds that are really closet indexers

will basically underperform for investors by definition.

Why, because they're basically an index fund, but

they charge high expenses leading to poor net returns.

Okay so let's look at the explicit and closet indexing by country here.

And this is kind of very fast, remember this is data December of 2010 here.

So you can see the sample of countries.

Asia Pacific is put together as one region.

You have kind of coverage of a lot of European countries here.

Germany, Spain, France, Poland, Switzerland a few examples.

The US here, you have Canada in here as well,

so there seems to be a lot of North America, European tilt toward the status.

We still have a lot of variation across countries here.

So the blue bars represent the share of the mutual fund industry,

the percent of total net assets under management for the mutual funds from that

country that are explicit index funds, that's the blue bar here on the bottom.

The red bar means these actively managed funds that seem to be closet index funds,

close to index funds, those are the ones really to avoid.

Because it's like hey, they're pretending they're actively managed and

charging high fees, but at the end of the day they're really just kind

of investing pretty close to like being an index fund.

So that means poor net returns for the investors and

then the truly active funds, those are the green bars at the top.

So let's look, compare with kind of a bench mark with the US.

So look at explicit index, the amount of index funds, so in the US,

December of 2010, look at stock funds, the calculations are about

28% of the industry is in index funds.

Okay, all right.

That seems to be the blue bar here for the US is pretty high relative to other

countries with the exception of Ireland and then particularly Switzerland.

There we see a large fraction of the assets here,

that are basically kind of an index fund.

But the US is generally higher than average here.

Switzerland has this kind of big, kind of over half of the mutual

funds in index funds, but that's unusual compared to the other countries..

Now, Poland is very interesting, because you see this gigantic, red bar.

So, no money in index funds, but closet indexing is very high there, like 58,

it looks like 58% of the Polish mutual funds are in these closet index funds.

So they're kind of claiming that they're actively managed funds, but

if you look at the performance, they're very closely aligned to the index funds,

a lot of overlap in the holdings with the underlying benchmarks.

That would maybe be a concern if I'm an investor in the Polish mutual funds here.

Okay, so Cremers, Ferreira, Matos and

Starks, they also look at investor cost around the world.

How do we measure investor's cost?

They're going to look at the annual expense ratio,

as we've looked at many a times, remember these include management fees, as well as

distribution fees called 12b-1 fees, that provides money to give to the broker.

So, those are the typical annual mutual fund fees.

Plus they're going to add one-fifth of any front-end load, if any, to the annual fee.

So if this is a mutual fund that charges a 5% fee to invest in the fund,

then they'll take one fifth of that and add that 1% to the annual fee.

So let's look at differences here across the countries,

and we're showing what are the expenses for explicit index.

Let's say expenses for index funds, those are the blue, I don't know,

let's call these stars or it looks like kind of people doing jumping jacks here,

for the blue, indicating explicit indexing.

The closet index fees are the red dots,

and then the green squares are the truly active funds.

And you can see what are the average expenses across the different funds,

across the country?

So actually some fascinating breakdown, as of December 2010.

So again let's look at Poland.

Like wow I don't want to kind of give, let the cat out of the bag here, but

I think I really want to be a mutual fund manager in Poland.

Look at these expenses.

So 3 to 4% per year being charged to investors in

these Polish mutual funds like, wow, okay, and

these closet index funds here are actually charging

4% per year, the actively managed funds 3%.

Just kind of literally off the charts here, how about we look at the US.

So you may complain about mutual fund fees for some funds in the US.

But maybe you shouldn't complain too much, it seems generally lower, or kind of

among the low end of the distribution, when you do an international comparison.

Kind of looking here, if you look for the fees for

index funds, I don't see any country that's charging

lower fees to kind of invest in index, index funds.

This is driven probably by competition with mutual funds that are indexes,

as well as exchange traded funds in the US are driving down these costs of

index products.

And then if you look at the actively manage funds,

where the costs are considerably higher in the US.

This green square is higher than the blue guy doing jumping jacks.

Almost a percent higher to invest in actively managed funds than index funds.

And the empirical evidence is,

you don't get the higher returns associated with this higher fee.

But look at what the US is charging for

actively managed funds compared to the other countries, right.

These green squares are generally much higher then this little over

1% that you see in the US.

So you see these higher actively managed fees in other countries

higher then what you see in the United States.

So key is to look at kind of the difference between the cost for

explicit index funds and this closet indexing.

So when you see kind of this big gap between kind of a blue jumping jack,

the blue guy doing jumping jacks and then this red circle, that shows

you the difference in fees for the actual index funds versus the closet index funds.

And that increase in fees generally leads to lower net returns,

lower Alpha for the investors in these closet index funds, okay?

So let's think about this, and I think I already gave a sneak preview.

Again, so excited about this.

I'm stealing the thunder from Le Penseur yet another time, okay.

So in what country do you want to be a mutual fund manager?

So let's think about giving the results,

the data that I just presented to you based on the academic study,

in what country do you want to be a mutual fund manager?

So think about that, and then I'll come back with my perspective.

So in what country do you want to be a mutual fund manager?

So I know this is a loaded question, but the evidence seems pretty clear.

Time to go to Poland and let's manage some mutual funds, right?

Let's look at this explicit and closet indexing by country.

Remember when we go to Poland,

we see over half of the money managed is actually in closet index funds.

So there you're charging the fee like you're an active manager working and

trying to beat the market.

But at the end of the day, you're holding a lot

of the same stocks with the same weight as your underline benchmarks.

So you aren't deviating that much from the market.

There isn't that much active management and yet

you're charging these high returns.

Okay and remember when we looked at the total fees charged,

Poland is literally kind of off the charts here in terms of these average annual

fees on the order of 3 to 4%.

Much higher than any of the other kind of countries, okay.

So there's only one problem with this strategy of let's go to Poland and

manage all this money and rake in this 3 to 4% per year.

The problem is, you didn't arrive in Poland, you're actually in Belarus.

Sorry about this.

Let's actually shift over to Poland with a geography lesson here,

in time to manage some mutual funds.

So my apologies, again, to John Oliver,

I had to try to do this geographic switcheroo one last time.

Don't worry we're not going to end the course on this lame joke.

Stay tuned for the course conclusion

[NOISE]

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