Swedroe: Underperformance Can Mean More Risk

December 20, 2017

Mutual fund investors’ tendency to chase past performance has been well documented—funds with superior relative performance within a category attract the lion’s share of future cash inflows.

For example, the study “Morningstar Ratings and Mutual Fund Performance,” by Christopher Blake and Matthew Morey, found that an amazing 97% of fund inflows went to four-star and five-star funds, while even three-star funds experienced outflows.

Given that the only way a fund manager can beat their benchmark and peers is to take positions that deviate from that benchmark (that is, to have a high active share), we are faced with questions about the potential for changing investment behaviors in response to a fund’s relatively poor performance in the first part of the year.

For instance, in the “tournament” of competition for investor assets, does a fund underperforming its benchmark and peers in the early part of the year increase its amount of active share and risk-taking in an effort to avoid being a loser?

Active Share’s Ebb & Flow

C. Wei Li, Ashish Tiwari and Lin Tong contribute to the literature with their November 2017 paper, “Mutual Fund Tournaments and Fund Active Share.”

The authors examined whether funds with relatively poor performance at the interim performance evaluation stage (that is, at the end of the third quarter of a given calendar year) tend to increase their active share during the later stage (the last quarter of the year), and, if they do so, how that impacts their future performance. Their study covered the period 1990 through 2015. Following is a summary of their findings:

  • Funds trailing after nine months increase their active share. This holds most strongly for mutual funds within “striking distance” of the winning funds (the performance deficit isn’t excessively large). In other words, funds with stronger tournament incentives experience a greater increase in idiosyncratic risk following an increase in active share induced by poor interim performance.
  • While an increase in funds’ active share does lead to a higher probability of increasing their ranking, it does not lead to improvement in funds’ fourth-quarter performance rankings. The increased chance of improving their relative rankings is balanced by the potential decline in performance that occurs with low probability but heightened severity.

These findings are consistent with prior studies that have found a mutual fund’s performance in the first half of the calendar year is negatively related to its change in risk (using such measures as volatility, beta and idiosyncratic risk) during the second half of the year.

The conclusion one could draw is that funds’ increase in active share isn’t likely to be motivated by information or skill (though, from an economic perspective, it is rational), but rather by the tournament in which they are competing for fund flows.

On the other hand, a fund leading in the rankings has an incentive to move its asset allocation closer to the average of its peer group, reducing active share and risk.

The bottom line for investors is that they need to be aware that the tournament for investor flows does appear to create incentives for actively managed funds underperforming in the first part of the year to increase their active share and risk-taking in the later part of the year.

However, there is no evidence this leads to any improvement in average performance; the increased likelihood of improved performance is offset by the increased likelihood of more severe underperformance. And, because most investors are risk-averse, they likely shouldn’t consider this a good trade-off.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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