Commonalities in investment strategy and the determinants of performance in mutual fund mergers

Abstract

This paper examines the determinants of cross-sectional variation in post-merger mutual fund performance. Mergers between funds with similar management objectives, as reflected by average portfolio book-to-market ratio, price–earnings ratio, beta and market capitalization values, outperform mergers between funds with dissimilar strategies. This superior performance transcends lower portfolio rebalancing costs which might be realized between merging funds which hold more assets in common. These results suggest that mutual fund mergers create collaborative benefits between funds with similar strategies. We also examine if fund governance structures influence the fund pairing process, testing if stronger fund oversight mitigates pairing mismatches. We find that less independent boards of trustees and boards with higher compensation are related to greater strategic mismatches between funds. These results suggest that more entrenched boards are more tolerant of fund mismatches which benefit the investment company, yet are not in investor’s best interests.

Introduction

The extent to which synergies motivate corporate mergers and influence post-merger operating performance has received considerable attention in the finance literature.¹ By combining common and complementary resources, the merged entity is potentially able to operate more efficiently and competitively than the stand alone firms. Despite similarities in purpose and motive between corporate and mutual fund mergers, little consideration has been given to the potential role of commonalities in mutual fund merger success.² More broadly, we seek to explain the substantial cross-sectional heterogeneity in mutual fund merger performance. Existing research has studied median post-merger outcomes, but the determinants of variation in performance remain largely unexplained.³

We hypothesize that post-merger performance is related to compatibility in the investment strategies between funds. Using portfolio holdings data, we construct measures of the commonality of the merging funds’ investment objectives and strategies and then relate those measures to merger success. We also seek to explore the factors which influence the fund pairing process, which determines the synergistic potential between funds. To our knowledge, this is the first paper to examine the determinants of cross-sectional variation in merger outcomes and the significance and determinants of the fund pairing process in mutual fund mergers.

As a concrete example of this empirical analysis, consider two potential matches in a merger; one between two small-cap, growth funds and the second between a small-cap, growth and large-cap, value fund. In the first case, similarities in asset characteristics minimizes non-discretionary portfolio rebalancing triggered by acquiring assets inconsistent with the merged entity’s investment objective. The acquiring fund manager gains insights into the investment strategy of the target fund and may utilize these insights to improve his current investment strategy. Considering that fund managers typically specialize in specific asset types and investment strategies, the acquiring manager has the necessary expertise to make effective and knowledgeable portfolio rebalancing decisions. In the second case, significant portfolio rebalancing costs are realized with few potential benefits, beyond economies of scale. From this perspective, mergers between funds with strategy commonalities are most likely value enhancing for investors.

On the other hand, complementarities between investment strategies may also create value. Differences in managerial regional or industry expertise between funds with broadly compatible investment objectives may strengthen the investment strategy of the merged entity. From this perspective, while broad commonalities are desirable, secondary complementary differences may also enhance fund value.

To quantify investment strategy commonalities between funds, we utilize a novel variable set constructed from portfolio holdings. We calculate the weighted-average price–earnings ratio (PE), book-to-market ratio (BM), market capitalization (MARCAP) and beta (BETA) for the target and acquirer portfolios and also examine the industry (SIC) and regional (REGION) focuses of each fund. These variables serve as indicators for the common fund objective classifications of growth versus value (PE and BM), risk (BETA), large versus small market capitalization (MARCAP) and sector or regional versus diversified focuses.

While controlling for portfolio rebalancing costs, we find that mergers between funds with greater differences in PE, BM and BETA realize significantly lower post-merger performance. For example, a one standard deviation increase in the difference in portfolio PE between funds results in a 1.4% drop in annualized post-merger performance. Further, in our sample of broadly diversified funds, we also find that variations in industry focus between the acquirer and target funds are performance enhancing. These results suggest that mergers between funds with common management objectives may generate strategic benefits which create value for investors. Additionally, after controlling for the implications of broad objective mismatches, strategic benefits may be realized via complementary differences in industry-level stock weights between funds.

Next we examine the factors which influence the fund pairing process, which we argue are broadly a function of merger incentives, timing and fund governance. First, consistent with motives to expeditiously minimize financial losses and performance history impacts associated with distressed funds, we find that mergers involving target funds with poorer performance and more negative net flows result in lower commonality mergers.

Second, we find evidence to suggest that the quality of the pool of available acquirer funds varies over time. Kapusta (2009) anecdotally suggests that mergers tend to cluster during periods of poor stock market performance. As net asset flows to equity funds similarly vary inversely with the economic cycle (Chalmers et al., 2011), the number of acquirer funds with free cash flows to finance acquisitions is depressed precisely at the time target fund demand is at its peak. Furthermore, as cyclical exposure varies systematically across investment objectives (for example, large relative to small-cap funds), these effects will be more pronounced in specific fund objectives, potentially necessitating across-objective mergers. Consistent with these factors limiting the depth of the acquirer fund pool during market downturns, we find that mergers undertaken following periods of low aggregate net flow to equity funds or undertaken when merger frequency is high, have incrementally lower strategy commonality.

Finally, we argue that more effective boards of governors will intervene on behalf of investors and will be related to higher investment objective commonality mergers. Drawing on proxies for board efficacy in Khorana et al. (2007), we find that funds with stronger governance structures are less tolerant of fund pair mismatches. Specifically, boards with a greater proportion of independent members and which are less entrenched are associated with higher strategy commonality mergers, and as such, are more likely value enhancing for investors.

The remainder of the paper is organized as follows. Section 2 describes the data and sample construction procedure. Section 3 defines the portfolio commonality variables and explores the determinants of post-merger performance. In Section 4 we focus on the determinants of portfolio commonalities, including fund governance considerations and in Section 5 we conclude. Institutional background on mutual fund mergers is provided in Appendix A.