Diversification and Portfolio Management of Mutual Funds

Mutual funds have become a popular structure for investors seeking exposure to financial markets. With thousands of funds in operation, it is unsurprising that mutual funds have become the largest means of investment in the USA, with almost $7.5 trillion of assets held at the beginning of 2004.¹ The structure provides investors with an opportunity to participate in securities markets without having to become money managers themselves. Furthermore, by pooling small amounts of money into a single fund value, individual investors are able to participate in investment strategies that would have otherwise been financially unfeasible.

The bull market in the USA during the 1990s resulted in an unprecedented number of investors choosing to invest in equities and in equity mutual funds. As of 30 June 2005 the market value of the stocks held in mutual fund portfolios accounted for nearly 22 percent of total US stockmarket capitalization versus 5 percent at the close of 1985.¹ In response to this trend, and to other incentives, financial intermediaries acting as fund managers are increasingly offering mutual funds based on a basket of other mutual funds. Among companies offering these so-called funds of funds (FOFs) are Fidelity, Goldman Sachs, T. Rowe Price, Schwab and Vanguard.

In most if not all countries the proportion of portfolio assets that investors allocate to foreign securities is clearly less than mean-variance analysis predicts. In Germany, for example, mutual funds hold only 66 percent of their investments in non-German securities while the latter represent almost 85 percent of the worldwide market value for bonds and 95 percent for equities. Even greater discrepancies exist for other financial intermediaries such as insurance companies or pension funds. Finally, the poorest portfolio diversification is exhibited by private German investors whose direct investments abroad only amount to 37 percent and 19 percent of their stock and bond holdings, respectively (for the year 2001: see Deutsche Bundesbank, 2001, 2004c).

The financial literature demonstrates that mutual funds offer an efficient solution to diversify capital investments. If possible, this diversification is the highest when all the markets can be allocated in portfolios. This makes it obvious that international funds should be the most efficient to choose. The benefits of portfolio diversification across international investments have been considered by several researchers (Lessard, 1973; Errunza, 1983; Bailey and Stulz, 1990; Bailey and Lin, 1992; Eun, Kolodney and Resnick, 1991). On one hand, is it possible to measure the market efficiency of funds? On the flip side, shared funds’ performance depend only upon managers’ ability to forecast the timing and selection of stock and bonds? This study attempts to answer these questions, considering, above all, the sensitivity of funds’ efficiency to monetary policy.

Alpha generation and portfolio construction are key parts of the investment process, together with portfolio implementation. The purpose of portfolio construction is to create and maintain, through a logical sequence of steps, optimal combinations of investment vehicles to achieve stated goals, starting from a set of forecasted asset returns. In other words, it is the process by which individual assets are combined together to create a portfolio which meets given objectives in terms of return and risk.

Households increasingly use mutual funds as their main long-term investment vehicles. Today, the number of mutual funds available exceeds 17,000 in the United States alone.¹ Market participants are therefore in need of valid, unbiased and straightforward information in order to select mutual funds with the best future prospects. But how does the average investor distinguish a superior mutual fund from another?

The growth in mutual fund investment has been substantial in the past decades. As a result, mutual funds are now one of the largest owners of equities. For example, in 2003 mutual funds owned almost 30 percent of outstanding equities in the USA and 15 percent in Europe (Fefsi, 2003). A growing body of research is investigating how mutual fund flows and stock prices are related (for example, Warther, 1995; Choe, Ko and Stulz, 1999; Fant, 1999; Edelen and Warner, 2001; Froot, O’Connel and Seasholes, 2001; Bekaert, Harvey and Lumsdaine, 2002). These studies document in general that there is a positive relationship between fund flows and stock prices. For the US market, for example, Warther (1995) reports that an unexpected flow into mutual funds of 1 percent of total stock fund assets corresponds to a 5.7 percent increase in the stock price index.

For the last two decades, the importance of mutual funds all over the world has increased enormously. In 1950, institutional investors in the USA held 6 percent of the stockmarket. Today that share represents over 50 percent of the stockmarket capitalization (around US dollars 30 trillion) and mutual funds are the more popular way to invest in the stockmarket. In Europe, the role of institutional investors is far from what it represents in the USA but it is growing at a very fast pace. By the end of the 1990s, total assets managed by mutual funds amounted to 70 percent, 60 percent, 90 percent, 60 percent and 200 percent of GNP, respectively, in Italy, Germany, France, Spain, the Netherlands and the UK.

Exchange Traded Funds (ETFs) are amongst the most popular mutual funds worldwide for both institutional and retail investors. In general, they offer lower fees and greater pricing transparency and liquidity than other mutual funds following the same investment strategies (Bansal and Somani, 2002; Ciccotello, Edelen, Greene and Hodges, 2002; Russel, Shekhar and Malhotra, 2004). ETFs come in a wide range of flavours but, by far, the dominant type of ETF is the passively-managed or index-tracking ETF.

The US mutual fund industry experienced tremendous growth during the past two decades. In November 2001 there were 8,282 mutual funds controlling over US$6.9 trillion dollars in assets, which by far exceeds 665 funds with US$241.4 billion in assets in 1981 (Investment Company Institute, 2001). With so many funds around, investors face a difficult task of selecting a fund with the desired risk and performance profile. Mutual fund categories composed of funds with a similar investment approach help investors to simplify their decision problem. Investors often first choose the category that suits their preferences and then select the best fund in that category, based on fund performance and/or other fund characteristics (see, for example, Kim, Shukla and Tomas, 2000). This investor behavior results in a specific structure of mutual fund flows, which depends on a fund’s relative performance within its category. As a consequence, the classification system also influences the incentives of fund managers, whose compensation is usually based on a percentage of fund assets (see, for example, Khorana, 1996). Given that top performers in a category attract most of the inflows, fund managers have an incentive to maximize their performance relative to other funds in the same category. This may not be consistent with their shareholders’ interests.

Academics and practitioners show a tremendous interest in the trending behavior of stock prices. A wide empirical literature establishes that common stocks exhibiting high returns on a period of 3–12 months (past winners) will overperform on subsequent periods. Moreover, past losers continue to be losers on future periods. This phenomenon, called momentum, represents one of the most important challenges for the concept of market efficiency. In practice, financial planners argue that momentum is one of the most effective investment vehicles.

Performance evaluation of professionally managed portfolios is a key topic of financial economics. Hence, most of the papers on mutual funds have examined whether portfolio managers are able to present superior performance in some sense previously defined.

The increase in the number of assets under management by mutual funds over the last two decades represents one of the most significant changes in the structure of household portfolios that has attracted much attention in the financial and economic literature. The mechanism through which investors select mutual funds involves economic as well as psychological factors, which makes the optimal selection problem difficult. This is especially true for global markets, where consumers can choose between local and foreign funds. The rapid expansion of the mutual fund industry around the world has in fact stimulated major players to look beyond national borders, distributing their products in markets that offer significant growth opportunities. Italy is one of these. In the period 1998–2002 alone, the assets managed by funds rose from €395,102 to €502,418 million, and the role of foreign firms has grown significantly in terms of market share reaching, at the end of 2002, about one-third of the total assets under management (AUM). Why such a foreign fund preference?

Codes of best practice originated in the early 1990s in the United Kingdom, the United States and Canada on account of a perceived lack of board oversight on effective corporate performance of leading companies. The Cadbury Report in the UK, the General Motors Board of Directors Guidelines in the USA, and the Dey Report in Canada have each proved influential sources for other guideline and code efforts.

Public spending for pensions is one of the most relevant items in government budgets. Such expenditure is considered to be a necessary intervention of the State in order to provide retired workers with a given level of income and consumption during old age. According to the simple, though effective life-cycle model, individuals smooths their consumption over their lives, so that during old age the saving rate becomes negative, that is consumption is sustained by a decrease in wealth. However, very often individuals are myopic and tend to save less money than they need during old age, and because of this there seems to be scope for public intervention.

The mutual fund market has grown so much over the last decade that we now have a real need for a criterion to evaluate portfolio managers. The mutual fund environment is characterized by asymmetric information, which makes analysing performance difficult, and promotes conflicts of interests about the use of market signals and control mechanisms to minimize agency costs.

The globalization of today’s economy has led to a renewed interest in financial systems that can explicate the differences in the evolution of market-based and bank-based systems.¹ In market-based systems, a legal separation is made between the typical commercial banking activity of resource-building, loan-granting and credit risk, and the development of activities such as stock-brokerage operations, wealth management, and assessing takeovers and acquisitions, which are carried out by other entities known as business or investment banks.