Do Mutual Funds Perform When it Matters Most to Investors? US Mutual Fund Performance and Risk in Recessions and Expansions

This paper shows that the stylized fact of average mutual fund underperformance documented in the literature stems from expansion periods when funds have statistically significant negative risk-adjusted performance and not recession periods when risk-adjusted fund performance is positive. These results imply that traditional unconditional performance measures understate the value added by active mutual fund managers in recessions, when investors' marginal utility of wealth is high. The risk-adjusted performance (or alpha) difference between recession and expansion periods is statistically and economically significant at 3% to 5% per year. Our findings are based on a novel multi-variate conditional regime-switching performance methodology used to carry out one of the most comprehensive examinations of the performance of US domestic equity mutual funds in recessions and expansions from 1962 to 2005. The findings are robust to the choice of the factor model (including bond and liquidity factor extensions), the use of NBER business cycle dates, fund load, turnover, expenses and percentage of equity holdings.

[1]  Anat R. Admati,et al.  Measuring Investment Performance in a Rational Expectations Equilibrium Model , 1985 .

[2]  M. C. Jensen.  The Performance of Mutual Funds in the Period 1945-1964 , 1967 .

[3]  Jeffrey A. Busse,et al.  Short-Term Persistence in Mutual Fund Performance , 2005 .

[4]  Roy. Henriksson,et al.  Market Timing and Mutual Fund Performance: An Empirical Investigation , 1984 .

[5]  Edwin J. Elton,et al.  A First Look at the Accuracy of the Crsp Mutual Fund Database and a Comparison of the Crsp and Morningstar Mutual Fund Databases , 2001 .

[6]  Andrew Ang,et al.  International Asset Allocation With Regime Shifts , 2002 .

[7]  Campbell R. Harvey.  Forecasts of Economic Growth from the Bond and Stock Markets , 1989 .

[8]  Arturo Estrella,et al.  The term structure as a predictor of real economic activity , 1991 .

[9]  Ľuboš Pástor,et al.  Liquidity Risk and Expected Stock Returns , 2003, Journal of Political Economy.

[10]  Martin J. Gruber,et al.  Another puzzle: the growth in actively managed mutual funds , 1996, Annals of Operations Research.

[11]  Jun Cai.  A Markov Model of Switching-Regime ARCH , 1994 .

[12]  Hong Zhang,et al.  Estimating the Dynamics of Mutual Fund Alphas and Betas , 2004 .

[13]  Edwin J. Elton,et al.  Efficiency with Costly Information: A Reinterpretation of Evidence from Managed Portfolios , 1993 .

[14]  Sheridan Titman,et al.  On Persistence in Mutual Fund Performance , 1997 .

[15]  Mark Rubinstein,et al.  The Valuation of Uncertain Income Streams and the Pricing of Options , 1976 .

[16]  Andrew Ang,et al.  Regime Switches in Interest Rates , 1998 .

[17]  Josef Lakonishok,et al.  Contrarian Investment, Extrapolation, and Risk , 1993 .

[18]  E. Fama,et al.  Common risk factors in the returns on stocks and bonds , 1993 .

[19]  Mutual Funds and Stock and Bond Market Stability , 1997 .

[20]  Tarun Chordia.  The Structure of Mutual Fund Charges , 1996 .

[21]  Sheridan Titman,et al.  Performance Measurement without Benchmarks: An Examination of Mutual Fund Returns , 1993 .

[22]  Kalok Chan,et al.  An Unconditional Asset-Pricing Test and the Role of Firm Size as an Instrumental Variable for Risk , 1988 .

[23]  F. Fabozzi,et al.  Mutual Fund Systematic Risk for Bull and Bear Markets: An Empirical Examination , 1979 .

[24]  E. Schaumburg,et al.  Do Funds Window Dress ? Evidence for U . S . Domestic Equity Mutual Funds ∗ , 2004 .

[25]  L. Glosten,et al.  Economic Significance of Predictable Variations in Stock Index Returns , 1989 .

[26]  Tobias J. Moskowitz,et al.  An Analysis of Covariance Risk and Pricing Anomalies , 2003 .

[27]  Raul Susmel,et al.  Volatility and Cross Correlation Across Major Stock Markets , 1998 .

[28]  E. Fama,et al.  Permanent and Temporary Components of Stock Prices , 1988, Journal of Political Economy.

[29]  Tarun Chordia,et al.  Momentum, Business Cycle and Time Varying Expected Returns , 2001 .

[30]  Gregory Kadlec,et al.  On the Perils of Financial Intermediaries Setting Security Prices: The Mutual Fund Wild Card Option , 2001 .

[31]  Lu Zheng,et al.  On the Industry Concentration of Actively Managed Equity Mutual Funds , 2003 .

[32]  Sanjiv Ranjan Das,et al.  Systemic Risk and International Portfolio Choice , 2002 .

[33]  Doron Avramov,et al.  Stock Return Predictability and Asset Pricing Models , 2003 .

[34]  Michael J. Cooper,et al.  Market States and Momentum , 2004 .

[35]  Jonathan D. Cryer,et al.  Time Series Analysis , 1986 .

[36]  R. Wermers,et al.  Investing in Mutual Funds When Returns are Predictable , 2005 .

[37]  William N. Goetzmann,et al.  Day Trading International Mutual Funds: Evidence and Policy Solutions , 2000 .

[38]  Luis M. Viceira,et al.  Consumption and Portfolio Decisions When Expected Returns are Time Varying , 1996 .

[39]  W. Ferson,et al.  Conditioning Manager Alphas on Economic Information: Another Look at the Persistence of Performance , 1996 .

[40]  Campbell R. Harvey,et al.  The Risk and Predictability of International Equity Returns , 1993 .

[41]  K. French,et al.  Expected stock returns and volatility , 1987 .

[42]  Douglas J. Skinner,et al.  Is Guidance a Macro Factor? the Nature and Information Content of Aggregate Earnings Guidance , 2005 .

[43]  Zhiwu Chen,et al.  Portfolio Performance Measurement: Theory and Applications , 1996 .

[44]  Suleyman Basak,et al.  Risk Management with Benchmarking , 2001, Manag. Sci..

[45]  Jeffrey A. Busse,et al.  Bayesian Alphas and Mutual Fund Persistence , 2003 .

[46]  W. Ferson.  Changes in Expected Security Returns, Risk, and the Level of Interest Rates , 1989 .

[47]  Min Wei,et al.  What Does the Yield Curve Tell Us About GDP Growth? , 2003 .

[48]  Russ Wermers,et al.  Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transactions Costs, and Expenses , 2000 .

[49]  David M. Kreps,et al.  Martingales and arbitrage in multiperiod securities markets , 1979 .

[50]  Christopher R. Blake,et al.  The Performance of Bond Mutual Funds , 1993 .

[51]  Mark Grinblatt,et al.  Do Industries Explain Momentum , 1999 .

[52]  Bruno Solnik.  The performance of international asset allocation strategies using conditioning information , 1993 .

[53]  R. Jagannathan,et al.  The Conditional CAPM and the Cross-Section of Expected Returns , 1996 .

[54]  Narasimhan Jegadeesh,et al.  Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency , 1993 .

[55]  Robert C. Klemkosky,et al.  THE PREDICTABILITY OF REAL PORTFOLIO RISK LEVELS , 1978 .

[56]  Pierluigi Balduzzi,et al.  Transaction costs and predictability: some utility cost calculations , 1999 .

[57]  Charles I. Plosser,et al.  International term structures and real economic growth , 1994 .

[58]  Douglas T. Breeden.  An Intertemporal Asset Pricing Model with Stochastic Consumption and Investment Opportunities , 1979 .

[59]  R. Stambaugh,et al.  Expectations and Volatility of Consumption and Asset Returns , 1990 .

[60]  Jennifer Conrad,et al.  Profitability of Momentum Strategies: An Evaluation of Alternative Explanations , 2001 .

[61]  René Garcia,et al.  Série Scientifique Scientific Series an Analysis of the Real Interest Rate under Regime Shifts , 2022 .

[62]  Mark Rubinstein,et al.  The Valuation of Uncertain Income Streams and the Pricing of Options , 1976 .

[63]  Eric Ghysels,et al.  On Stable Factor Structures in the Pricing of Risk: Do Time-Varying Betas Help or Hurt? , 1998 .

[64]  Stephen K. McNees.  How large are economic forecast errors , 1992 .

[65]  Jason T. Greene,et al.  The Dilution Impact of Daily Fund Flows on Open-End Mutual Funds , 2000 .

[66]  R. Kalra,et al.  Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transactions Costs, and Expenses , 2001 .

[67]  David K. Musto,et al.  How Investors Interpret Past Fund Returns , 2000 .

[68]  Wayne E. Ferson,et al.  Measuring Fund Strategy and Performance in Changing Economic Conditions , 1996 .

[69]  Sheridan Titman,et al.  Portfolio Performance Evaluation: Old Issues and New Insights , 1989 .

[70]  P. Samuelson.  LIFETIME PORTFOLIO SELECTION BY DYNAMIC STOCHASTIC PROGRAMMING , 1969 .

[71]  Michael W. Brandt.  Estimating Portfolio and Consumption Choice: A Conditional Euler Equations Approach , 1999 .

[72]  K. Brown,et al.  Of Tournaments and Temptations: An Analysis of Managerial Incentives in the Mutual Fund Industry , 1996 .

[73]  B. Malkiel.  Returns from Investing in Equity Mutual Funds 1971 to 1991 , 1995 .

[74]  Tarun Chordia,et al.  Predicting Stock Returns , 2005 .

[75]  A. Lynch,et al.  Does Mutual Fund Performance Vary Over the Business Cycle? , 2002 .

[76]  Andrea Prat,et al.  Risk Taking and Optimal Contracts for Money Managers , 2003 .

[77]  R. C. Merton,et al.  Lifetime Portfolio Selection under Uncertainty: The Continuous-Time Case , 1969 .

[78]  Campbell R. Harvey,et al.  The Variation of Economic Risk Premiums , 1990, Journal of Political Economy.

[79]  Massimo Guidolin,et al.  Size and Value Anomalies under Regime Shifts , 2007 .

[80]  Woodrow T. Johnson.  Predictable Investment Horizons and Wealth Transfers Among Mutual Fund Shareholders , 2003 .

[81]  Lu Zheng.  Is Money Smart? A Study of Mutual Fund Investors' Fund Selection Ability , 1999 .

[82]  N. Barberis.  Investing for the Long Run When Returns are Predictable , 2000 .

[83]  Ľuboš Pástor,et al.  Credit Suisse Asset Management , 2000 .

[84]  G. Schwert,et al.  Stock Returns and Real Activity: a Century of Evidence , 1990 .

[85]  L. Glosten,et al.  On the Relation between the Expected Value and the Volatility of the Nominal Excess Return on Stocks , 1993 .

[86]  Allan Timmermann,et al.  Business Cycle Asymmetries in Stock Returns: Evidence from Higher Order Moments and Conditional Densities , 2001, SSRN Electronic Journal.

[87]  Marcin T. Kacperczyk,et al.  On the Industry Concentration of Actively Managed Equity Mutual Funds , 2004 .

[88]  P. Veronesi.  Stock Market Overreaction to Bad News in Good Times: A Rational Expectations Equilibrium Model , 1999 .

[89]  Would Mutual Funds Bite the Hand that Feeds Them? Business Ties and Proxy Voting , 2005 .

[90]  Stanley J. Kon.  The Market-Timing Performance of Mutual Fund Managers , 1983 .

[91]  M. Lettau,et al.  Resurrecting the (C)Capm: A Cross-Sectional Test When Risk Premia Wre Time-Varying , 1999 .

[92]  Jeffrey Pontiff,et al.  How Are Derivatives Used? Evidence from the Mutual Fund Industry , 1999 .

[93]  A. Timmermann,et al.  Economic Implications of Bull and Bear Regimes in UK Stock Returns , 2003 .

[94]  R. Stambaugh,et al.  On the Predictability of Stock Returns: An Asset-Allocation Perspective , 1995 .

[95]  M. Spiegel,et al.  Improved Forecasting of Mutual Fund Alphas and Betas , 2006 .

[96]  Stephen Gray.  Modeling the Conditional Distribution of Interest Rates as a Regime-Switching Process , 1996 .

[97]  P. Veronesi.  How Does Information Quality Affect Stock Returns? , 1999 .

[98]  James D. Hamilton.  A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle , 1989 .

[99]  Ravi Jagannathan,et al.  Assessing the Market Timing Performance of Managed Portfolios , 1985 .

[100]  James D. Hamilton,et al.  A Reexamination of the Predictability of Economic Activity Using the Yield Spread , 2000 .

[101]  Sanford J. Grossman,et al.  The Determinants of the Variability of Stock Market Prices , 1980 .

[102]  Robert A. Korajczyk,et al.  Do Arbitrage Pricing Models Explain the Predictability of Stock Returns? , 1995 .

[103]  Allan Timmermann,et al.  Firm Size and Cyclical Variations in Stock Returns , 2000 .

[104]  James D. Hamilton,et al.  Autoregressive conditional heteroskedasticity and changes in regime , 1994 .

[105]  Andrea Frazzini,et al.  Dumb Money: Mutual Fund Flows and the Cross-Section of Stock Returns , 2005 .

[106]  Roger M. Edelen.  Investor flows and the assessed performance of open-end mutual funds , 1999 .

[107]  J. Campbell.  Stock Returns and the Term Structure , 1985 .

[108]  Lu Zheng,et al.  Family Values and the Star Phenomenon: Strategies of Mutual Fund Families , 2003 .

[109]  Donald B. Keim,et al.  Predicting returns in the stock and bond markets , 1986 .

[110]  Edwin J. Elton,et al.  Fundamental Economic Variables, Expected Returns, and Bond Fund Performance , 1995 .

[111]  Marcelle Chauvet,et al.  Coincident and Leading Indicators of the Stock Market , 1999 .

[112]  Jerold B. Warner,et al.  Evaluating Mutual Fund Performance , 1997 .

[113]  A Reexamination of the Predictability of Economic Activity Using the Yield Spread , 2002 .

[114]  Russ Wermers,et al.  Is Money Really 'Smart'? New Evidence on the Relation between Mutual Fund Flows, Manager Behavior, and Performance Persistence , 2003 .

[115]  M. Massa,et al.  Mutual Funds and the Market for Liquidity , 2004 .

[116]  A. Timmermann,et al.  Strategic Asset Allocation and Consumption Decisions Under Multivariate Regime Switching , 2004 .

[117]  Peter D. Wysocki,et al.  Do Managers Withhold Bad News? , 2005 .

[118]  Massimo Massa,et al.  Favoritism in Mutual Fund Families? Evidence on Strategic Cross-Fund Subsidization , 2004 .

[119]  B. Bernanke,et al.  Agency Costs, Net Worth, and Business Fluctuations , 1988 .

[120]  Glenn Ellison,et al.  Risk Taking by Mutual Funds as a Response to Incentives , 1995, Journal of Political Economy.

[121]  Lars Peter Hansen,et al.  THE ROLE OF CONDITIONING INFORMATION IN DEDUCING TESTABLE RESTRICTIONS IMPLIED BY DYNAMIC ASSET PRICING MODELS1 , 1987 .

[122]  Stanley J. Kon,et al.  Estimation of Time-Varying Systematic Risk and Performance for Mutual Fund Portfolios: An Application of Switching Regression , 1978 .

[123]  J. Kallberg,et al.  The Value Added from Investment Managers: An Examination of Funds of REITs , 2000, Journal of Financial and Quantitative Analysis.

[124]  Bruce E. Hansen,et al.  Inference When a Nuisance Parameter Is Not Identified under the Null Hypothesis , 1996 .

[125]  Thomas H. McCurdy,et al.  Duration-Dependent Transitions in a Markov Model of U.S. GNP Growth , 1994 .

[126]  H. Shin.  Disclosures and Asset Returns , 2001 .

[127]  Michael J. Schill,et al.  Conditional Market Timing with Benchmark Investors , 1998 .

[128]  Russ Wermers,et al.  Can Mutual Fund 'Stars' Really Pick Stocks? New Evidence from a Bootstrap Analysis , 2005 .

[129]  Jessica A. Wachter,et al.  Should Investors Avoid All Actively Managed Mutual Funds? A Study in Bayesian Performance Evaluation , 2001 .

[130]  R. Litzenberger,et al.  SKEWNESS PREFERENCE AND THE VALUATION OF RISK ASSETS , 1976 .

[131]  The Real Term Structure and Consumption Growth , 1988 .

[132]  Andrew J. Filardo.  Business-Cycle Phases and Their Transitional Dynamics , 1994 .

[133]  William N. Goetzmann,et al.  Survivorship Bias in Performance Studies , 1992 .

[134]  P. Veronesi,et al.  Excess Comovement of International Stock Markets in Bad Times: A Rational Expectations Equilibrium Model , 2008 .

[135]  Edward S. O'Neal,et al.  Mutual Fund Brokerage Commissions , 1996 .

[136]  M. C. Jensen,et al.  Risk, the Pricing of Capital Assets, and the Evaluation of Investment Portfolios , 1969 .

[137]  Lu Zheng,et al.  Unobserved Actions of Mutual Funds , 2005 .

[138]  Robert F. Whitelaw.  Time Variations and Covariations in the Expectation and Volatility of Stock Market Returns , 1994 .

[139]  Lu Zhang,et al.  Is Value Riskier than Growth? , 2003 .

[140]  Wilbur G. Lewellen,et al.  Market Timing and Mutual Fund Investment Performance , 1984 .

[141]  René Garcia,et al.  Série Scientifique Scientific Series Nº 95s-7 Asymptotic Null Distribution of the Likelihood Ratio Test in Markov Switching Models , 2022 .

[142]  Marcin T. Kacperczyk,et al.  Fund Manager Use of Public Information: New Evidence on Managerial Skills , 2007 .

[143]  Douglas T. Breeden,et al.  Consumption, Production, Inflation and Interest Rates: A Synthesis , 1986 .

[144]  William N. Goetzmann,et al.  Mutual Fund Styles , 1996 .

[145]  Ravi Jagannathan,et al.  A contingent claim approach to performance evaluation , 1993 .