literature review of mutual funds 23.10.14

8/10/2019 Literature Review of Mutual Funds 23.10.14

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REVIEW OF LITERATURE

The published work relating to the topic is reviewed by the

Researcher. The relevant literature is reviewed on the basis of Books,

Periodicals, News Papers and Websites. The detailed review is given

below:-

Harry Markowitz (1952)1provides a theory about how investors

should select securities for their investment portfolio given beliefs about

future performance. He claims that rational investors consider higher

expected return as good and high variability of those returns as bad. From

this simple construct, he says that the decision rule should be to diversify

among all securities, securities which give the maximum expected

returns. His rule recommends the portfolio with the highest return is not

the one with the lowest variance of returns and that there is a rate at

which an investor can increase return by increasing variance. This is the

cornerstone of portfolio theory as we know it.

His portfolio theory shows that an investor has a choice of

combinations of return and variance depending on the percentage of

wealth invested in various combinations of risky assets. From this, he

1'Harry Markowitz "Portfolio Selection", Journal of Finance -, March 1952, Vo1.7, pp. 77-91


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shows that a plot of all possible combinations of wealth divided among

possible combinations of securities will result in a circle. This circle will

be plotted on an xy grid with return plotted on one axis and risk, as

measured by variance on the other axis. The notion that investors desire

to maximize return for a given risk gives rise to some combinations of

securities dominating others in terms of risk and return characteristic.

These dominant portfolios are said to lie on the "efficient frontier".

If return is plotted on the vertical axis, variance on the horizontal

axis, and the circle of all possible combinations of risky assets is plotted

in return and variance space to obtain the efficient frontier, a point can be

plotted where the vertical distance represents the return on the risk-less

asset and the horizontal distance represents the risk (which is zero). A

straight line can be drawn from this point so that it touches the highest

point of the efficient frontier. This line is termed the "Capital Market

Line" (CML). If investors can both borrow and lend money at the risk

free rate of interest, they can select any level of return and variance they

are most satisfied with on that line. Any point on that line will provide a

higher return for the selected level of variance. The CML attracted a lot

of criticisms by the authors of Late 60's.


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The Wharton (1962)2study investigated mutual fund performance

in period t and the net inflow of money, or growth, in period t+1. The

study found only a weak positive relationship for common stock funds.

The methodology used was a two-by two contingency table that

compared the lower half of a particular sample in performance with the

lower half in growth, and conversely. This particular methodology has

been criticized. Smith (1978) called it "coarse" on the ground that it does

not use the data in the most efficient manner and is therefore not a strong

test of the performance-growth relationship.

`William Sharpe (1964)3and John Lintner (1965)

4separately extend

the work of Markowtiz. They show that the theory implies that the rates

of return from efficient combinations of risky assets move together

perfectly (will be perfectly correlated). This could result from their

common dependence on general economic activity. If this is so,

diversification among risky assets enables investors to escape from all

risks except the risk resulting from changes in economic activity.

Therefore, only the responsiveness of an asset return to changes in

2Wharton School of Finance and Commerce, A study of Mutual Funds, University Pennsylvania, U.S

Government Printing Office, 1962.

3Sharpe, "Capital Asset Prices - A Theory of Market Equilibrium Under conditions of Risk", Journal

of Finance, September 1964, pp 425-442.

4 John Linter, "Security Prices, Risk and Maximal Gains from Diversification", Journal of Finance,

December 1965, pp.5137.615.


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economic activity is relevant in assessing its risk. Investors only need to

be concerned with systematic risk [beta], not the total risk proposed by

Markowtiz. This gave birth to the "Security Market Line" (SML). The

difference between the Capital Market Line (CML) and SML is the

measure of risk used for the horizontal axis. The CML uses the variance

of returns, whereas the SML uses the systematic risk termed beta. Beta is

defined as the covariance between a security (or portfolio of securities)

and the market as a whole, divided by the variance of the market. The

market as a whole is considered the point of tangency between the SML

and the efficient frontier. This is the foundation for the Capital Asset

Pricing Model (CAPM).

Sharpe (1966)5in order to evaluate the risk-adjusted performance

of mutual funds introduced the measure known as reward to variability

ratio (Currently Sharpe Ratio). With the help of this ratio he evaluated the

return of 34 open-end mutual funds in the period 1945-1963. The results

showed that to a major extent the capital market was highly efficient due

to which majority of the sample had lower performance as compared to

the Dow Jones Index. Sharpe (1966) found that from 1954 to 1963 only

11 funds outperformed the Dow-Jones Industrial Average (DJIA) while

23 funds were outperformed by the DJIA. Study concluded that the

5Sharpe (1966), Mutual Fund Performance, The Journal of Business, 39, 1, 119-138.


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mutual funds were inferior investments during the period. Results also

showed that good managers concentrate on evaluating risk and providing

diversification.

Jensen (1968)6developed own measure known as Jensen's Alpha

to examine the risk- portfolios' risk-adjusted performance and estimate

the predictive ability of mutual fund managers. The measure was based

on the theory of the pricing of capital assets. For this purpose a sample of

115 open end mutual funds (for which net asset and dividend information

was available) was taken for the period 1955-1964. After applying the

Jensen measure he concluded that stock prices could not be forecasted

accurately with the help of mutual funds therefore buy and hold strategy

could not be used to take any advantage. Similarly there is slight evidence

that an individual mutual fund can achieve returns higher than a portfolio

comprised of randomly selected shares.

Carlson (1970)7 conducted a research to analyze the predictive

value of past results in forecasting future performance of mutual funds for

the period 1948-1667. The author also examined the efficiency of market

and identified the factors related to the fund performance. First of all he

6Jensen (1968), The Performance Of Mutual Funds In The Period 1945-1964, Journal of Finance, 23,

2, 1-36.

7Carlson (1970), Aggregate Performance of Mutual Funds, The Journal of Financial and Quantitative

Analysis, 5, 1, 1-32.


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constructed indices for three types of mutual funds (Diversified common

stock, Balanced, Income) and compared these indices with the market

indices. In order to analyze the performance regression was used. The

results provide empirical support to the return-risk postulate of the capital

asset pricing model and concluded that whether mutual funds outperform

the market depends on the selection of both the time period and market

proxy. The author also concluded that past performance showed little

predictive value and that the performance was positively related to the

availability of new cash resources for investment purposes.

Spitz (1970)8 related mutual growth to performance. Growth was

measured by net cash inflows which were defined as sales of capital

shares less the redemption of capital shares. A shortcoming of this growth

variable is that it includes investment returns (dividends and capital

gains) that are automatically reinvested. This procedure is incorrect

because additional shares purchased in this manner do not meet the

definition of new money because some of the shares purchased simply

compensate for payments; performance was measured by adding realized

and unrealized capital gains with gross income minus expenses (which

included management expenses). The data was on a yearly basis and

consisted of only 20 mutual funds over the time period from 1960 to

8Spitz, "Mutual Fund Performance and Cash inflows", Applied Economics, Vol.2, 1970, pp. 141-145.


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1967. Using time series correlations, Spitz tested two models. The first

was a contemporaneous model that related performance and growth in the

same period. The second model related growth in time period t with

performance in period t+1. The author concluded that the results were

generally insignificant.

Arditti (1971)9

criticized the reward-to-variability criterion

proposed by Sharpe (1966) on the grounds that it utilized only the first

two moments of the probability distribution of returns. Author proposed

that the third moment, a measure of the direction and size of the

distribution's tail, be included in the analysis. Arditti (1971) further

argued that investors preferred positive skewness because positive

skewness implied greater probability of higher return. Therefore assets

with relatively low reward-to-variability ratios would not be inferior

investments if ratios also have relatively high third moments (high

positive skewness). Furthermore author reexamined the Sharpe (1966)

data with this additional requirement and found that average fund

performance was not inferior to Dow Jones Industrial Average (DJIA)

performance because the skewness of the Dow Jones Industrial Average

(DJIA) return distribution was significantly less than fund skewness.

9 Arditti (1971), Another Look at Mutual Fund Performance, Journal of Financial and Quantitative

Analysis, 6, 909-912.


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Mcdonald (1973)10

developed a model to evaluate the investment

performance of funds holding securities in two countries. For this purpose

a sample of eight of the oldest French mutual funds was taken. The

monthly returns of these funds were calculated and analyzed for the

period 1964-1969. The results showed that the funds generally produced

superior risk-adjusted returns and that the French market was inefficient

with respect to the completeness and speed of dissemination of

information. The author concluded that those funds which invested in the

French market in 1964-69 generally achieved lower return at a given

level of variance than that reflected in the U.S. market returns.

Fama and McBeth (1973)11

examine the return of securities, using

OLS techniques and find that the CAPM, or market model, explains

returns well. They examined three testable implications of the market

model, (1) the relationship between risk and return is linear, (2) beta is a

complete measure of risk, and (3) higher risk should be associated with

higher returns. They conclude that none of the three testable implications

can be rejected. The results are consistent with efficient markets and a

sound asset pricing model, however, the estimated intercept was

somewhat higher than Rf.

10Mcdonald (1973) also found that the funds were generally able to attain superior returns relative to

naive portfolio strategy.

11Fama and McBeth, Risk Return and Equilibrium: Empirical Tests Journal of Political Economy,

May-June 1973, pp.607-636.


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McDonald (1974)12

conducted a research to examine the

objectives and performance (risk and return) of American mutual funds in

the period 1960-1669. Sample of 123 American mutual funds was

analyzed by using Treynor (1965) and Sharpe (1966) indexes. The results

indicated that stated objectives were significantly related to subsequent

measures of systematic risk and total variability. Therefore the funds with

aggressive objectives generally produced better performance. The results

also showed that 67 funds perform better than the stock market average in

case of Treynor's (1965) index while in case of Sharpe's (1966) index

only 39 mutual funds showed higher performance than the stock market

average. The author concluded that Average fund return increases with

increase in risk.

A study by Smith (1978)13

related mutual fund growth to fund

performance and found some positive relationships after adjusting for risk

using Jensen's Alpha. In carrying out the study, Smith tested two

hypotheses. The first was Mutual funds that improve their

performance in a given period, experience a growth rate in assets under

its management during the next period that is no different from that of

mutual funds that did not improve their performances...However, Smith

12McDonald (1973), Mutual Fund Performance: Evaluation of Internationally-Diversified Portfolios,

The Journal of Finance, 28, 5, 1161-1180.

13Smith, V., Is fund Growth Related to Fund Performance? The journal of Portfolio Management,

Spring 1978, pp 49-54.


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correctly recognized that the growth of a mutual fund's assets may be the

result of both new money flowing into the fund and to successful

investment performance. Smith accounted for this in his second

hypothesis by defining the growth in mutual funds in terms of

"outstanding shares" instead of "assets." However, using the growth in

outstanding shares incurs the same criticism as it did in Spitz's study, that

is, it incorrectly includes the reinvestment of dividends as new money.

Also, Smith used the "improvement" in investment performance as the

measurement variable affecting mutual fund money flows. The problem

with measuring the "improvement" in performance is that it ignores the

total, or overall, performance position of a fund relative to other funds.

To illustrate, the return, or investment performance of a fund may have

increased dramatically, but the fund may still have a total return that is

well behind other funds. A large amount of new money may not flow into

such a fund despite its recent performance improvement. Yet, Smith's

methodology examined exactly that aspect of the question.

To test his hypotheses Smith selected as performance variables the

non-risk adjusted performance measure developed by Jensen (1968)14

known as Jensen's Alpha which was estimated over the previous five-year

period. Growth periods of six and twelve months were examined

14 Jensen "The Performance of Mutual Funds in the Period 1945-1964", Journal of Finance, Vol.23.

May 1968, pp 389-416.


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subsequent to the performance estimates. The methodology consisted of

rank correlations relating the "change" in performance to the "change" in

growth in subsequent periods. The data used to test the first hypothesis

comprised of 74 common stock mutual funds for the time period 1964 to

1975. The second data set comprised 50 funds from 1960 to 1973. In his

analysis, Smith found no significant relationship when the Forbes rating

was related to either the growth in assets or the growth in shares. When

Jensen's Alpha was used as the explanatory variable, some significance

was found, but not enough to reject the null hypothesis. In addition to the

problems mentioned above, Smith himself noted that his study had two

basic shortcomings. The first was the small data base and the second was

that money flows may depend on variables other than the Forbes rating or

Jensen's Alpha.

Roll (1978)15

shows there is ambiguity when performance is

measured by the SML. The difficulty is that different market indices

provide different rankings. While previous work was mathematically,

theoretically, and intellectually rigorous, the author not only defined this

market portfolio but made an attempt to estimate a covariance matrix

with it. Theoretically, the market portfolio is the composition of all

investible assets. In practice, since this is not measurable, some proxy

15Roll "Ambiguity When Perfomncc is measured by the Securities Market Line", Journal of Finance,

Vol 33, September 1978, pp 1051-1069.


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must be used for the true market portfolio. The trouble is that even an

equally weighted and value weighted index of the same securities can

produce conflicting performance results when used as the proxy for the

market portfolio. The ambiguity of the SML arises because a different

beta can be generated for assets and portfolios by using different indices.

Therefore, beta is not an attribute of the individual asset. Beta is a

measure of the risk of an asset if included in a portfolio of risky assets

consisting of the market portfolio and a risk-less asset. Therefore,

differences in portfolio selection ability cannot be measured by the SML

criterion. If the index is ex-ante mean variance efficient, it is impossible

to discriminate between winners and losers. If the index is not ex-ante

mean-variance efficient, designating winners and losers is possible, but

another index can designate different winners and losers and there is no

way to determine which one is correct.

Therefore, Roll criticizes CAPM by saying that (1) the only valid

test is if the index is efficient, (2) if an index that is ex-post efficient is

chosen, every security will plot on a straight line, and (3) if the index is

inefficient etc-post, abnormal returns can be detected and ranking is

possible. Despite Roll's critique, research using CAPM continued. Since

both the Jensen and Treynor measure use a beta for the market portfolio,

they are both subject to this problem of determining the true market


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portfolio and measuring its returns. This criticism is now far more

troubling. Many anomalies to CAPM have been documented since the

mid-1970's.

Basu (1977)16

shows that low price to earnings ratio portfolios

have greater risk adjusted returns than high P/E ratio portfolios. Banz

(1981)17

finds that returns on common stocks with low market equity

have greater risk adjusted returns than those stocks with high market

equity. However, the "size effect" is not a linear explanatory variable.

Copeland and Mayers (1982)18

show that a portfolio of stocks denoted

as "buy" by "Value Line" outperform a portfolio of "sell" stocks. Basu

(1983)19

shows that the P/E ratio effect that presented in 1977 also existed

after adjusting for the size effect reported by Banz (1981) Stickel

(1985)20

shows that changes in "Value Line" rankings are followed by

abnormal returns and this effect is greater for smaller firms. De Bondt

16Basu, "Investment Performance of Common Stocks in relation to Their Price Earnings Ratios: A Test

of the Efficient Market Hypothesis", Journal of Finance June 1977.

17Banz, "The Relationship between Market Value and Common Stocks" Journal of Financial

Economics, March 1981, pp.3- 18.

18Copeland and David, "The Value Line Engima (19641978): A Case Study of Performance

Evaluation Issues", Journal of Financial Economics, November 1982.

19Basu, "The Relationship between Earnings Yield, Market Value, and Return for NYSE Common

Stocks Further Evidence", Journal of Financial Economics, June 1983.

20

Stickel, "The Effect of Value Line investment Survey Rank Changes on Common Stock Prices",Journal of Financial Economics, Vol. 14, No.1, 1985.


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and Thaler (1985)21

test the "Overreaction Hypothesis" which claims

investors overreact to news and overweight recent information. They

conclude "loser" portfolio outperform "winner" portfolios by

approximately 25 per cent. Reinganum (1988)22

finds that price / book

ratios explain stock returns. Further, portfolios of stocks with price / book

ratios of less than one significantly outperform the S&P 500 index. Fama

and French (1988)23

show that dividend yields can forecast future

returns Lehmann (1990)24

finds that "winners" and "losers" one week

experience significant reversals the next week and that significant excess

returns can be generated by buying "losers". Jegadeesh (1990)25

examines the return on individual securities and provides evidence of

stock return predictability through a mean reversion process. Stocks that

perform exceptionally well in one year perform poorly in the next year,

whereas poorly performing stocks improve performance in the following

year. Lo and MacKinley (1990)26

also find contrarian trading rule

profits.

21De Bondt and Thaler, "Does the stock market over react?", Journal of Finance, Vol.40, 1985.

22Reinganum, The Anatomy of a Stock Market Winner", Financial Analysis Journal March - April,

1988.

23Fama and French, "Dividend Yields and Expected Stock Returns" Journal of Financial Economics,

October 1988.

24Lechman, "Fads, Martingales and Market efficiency" Quarterly Journal of Economics, February

1990.

25Jagadesh, "Evidence of Predictable Behavior of Security Returns", Journal of Finance, July 1990.

26

Lo and Craig, "When are Contrarian Profits due to Stock Market Overreaction?" Review of FinancialStudies, Vol.3, No.2, 1990.


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Miller and Nicholas (1980)27

conducted a research to examine the

risk-return relationships in the presence of non-stationarity in order to

obtain more precise estimates of alpha and beta. For this purpose this

study applied partition regression and a partition selection rule for

estimating the traditional CAPM in case of non-stationarity. Study

applied these procedures to price appreciation data for the market and 28

mutual funds for the period of 1973-1974. The results indicated a good

deal of non-cosistency in the risk-return relationships. The results showed

some weak positive relationships and some weak negative relationships

between betas and the rate of return for the market. On the other hand

results showed some weak positive relationships and some weak negative

relationships between betas and alphas. However, no general, statistically

significant relationships of either type were found.

In order to analyze the market-timing performance of mutual funds

a study was conducted by Henriksson (1984)28

. For this purpose a

sample of 116 open-end mutual funds from February 1968 to June1980

was taken. By using parametric and nonparametric techniques author

examined the performance of these open-end mutual funds using monthly

data. The returns data included all dividends paid by the fund and were

27Miller and Nicholas (1980), Nonstationarity and Evaluation of Mutual Fund Performance, The

Journal of Financial and Quantitative Analysis, 15, 3, 639 -654.

28Henriksson (1984), Market Timing and Mutual Fund Performance: An Empirical Investigation, The

Journal of Business, 57, 1, 73-96.


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net of all management costs and fees. Both the parametric and

nonparametric tests showed that mutual fund managers were unable to

follow a successful investment strategy. The results also showed that no

evidence was found that forecasters were more successful in the market-

timing activity with respect to predicting large changes in the value of the

market portfolio relative to smaller changes.

Woerheide (1982)29

used a somewhat different approach in

attempting to explain mutual fund money flows. The major objective of

his study was to identify the selection criteria investors seem to use in

buying and selling mutual fund shares once an investment objective had

been selected. Woerheide defined success as the selection by investors of

a given mutual fund, as measured by the net sales ratio. The net sales

ratio was defined as gross sales, less redemption, divided by total assets

at the start of the year. Woerheide's definition of success contains the

same error as the Spitz and Smith studies described above, that is, the

sales figures include reinvested dividends which should not be included

as new money. The selection criteria evaluated included two groups. The

first group was called "efficient market criteria," and the second group

"other factors." The rationale for the efficient market criteria was that

investors would prefer funds that were managed so as to maximize the

29Woerheide, "Investor Response to suggested Criteria for the Selection of Mutual Funds", Journal of

Finance and Quantitative Analysis, March 1982, pp 129-137.


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fund's return while minimizing its risk. The return-sensitive variables

were whether or not there was a load charge, the management expense

ratio, the portfolio turnover ratio, and the brokerage expense ratio. The

risk reducing variable was the number of different securities within the

mutual fund portfolio. This variable was selected on the basis that the risk

of a portfolio has been shown to decrease as the number of securities in it

increases. The "other" category of explanatory variables included items

that may influence an investor's selection of a particular mutual fund, but

were not directly related to the risk and return characteristics of the fund.

These variables included marketing strategy, mutual fund size, and prior

performance as measured by non-risk-adjusted rates of return.

To test his selection criteria, Woerheide confined his data to one

objective classification as defined by the 1977 edition of the "Investment

Companies" publication. The funds used in his study were classified as

"long-term growth, income secondary." The data used for each variable

tested depended on data availability, but covered the time period from

1972 to 1976 for 15 to 44 funds. The test intervals were one and three

year time periods. The methodologies varied according to the variables

being tested, but included correlation analysis, regression analysis, and a

comparison of means and standard deviations.


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Woerheide found no statistical significance for any of the efficient

market variables, and only weak statistical support for two of the "other"

variables, specifically, mutual fund size and prior return performance.

The marketing program variable was insignificant. Concerning the

direction of the relationship, Woerheide found that the absence of a load

charge was generally negatively related to his performance variable while

the management expense ratio had a positive sign. Woerheide concluded

that these relationships were incorrect. The turnover ratio, the brokerage

ratio, and the marketing program variables have a positive relationship.

These relationships were considered appropriate by Woerheide. The

variable representing the size of the mutual fund produce conflicting

results with respect to the direction of the relationship. Woerheide's

approach was sound in that he attempted to determine whether investors

use risk and return variables or "other" variables in selecting mutual

funds. But, his performance measures are not risk adjusted, and he

considered too few "other" explanatory variables. Overall, Woerheide's

conclusions must be questioned because the data base was small both in

terms of the number of funds and the time span.

In 198430

, Chang and Eric Chieh developed an investment

performance evaluation model in the multi-factor arbitrage pricing theory

30Chang, Eric, "Market timing and Mutual fund Investment Performance" Journal of Business January

1984, pp 57-72.


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framework and then empirically compared and applied; three investment

performance evaluation methodologies examined are the multi-factor

selectivity model, the single-factor selectivity model, and the single-

factor selectivity and timing model. Several criteria for comparison are

developed and the results are reported. The actual investment

performance of a sample of mutual funds is evaluated according to these

three methodologies. In general, they have provided evidences to show

that both the multi-factor selectivity model and the single-factor

selectivity and timing model are superior to the single-factor selectivity

model. However, the major conclusion about the non-superiority of

mutual funds investment performance drawn from the tests based on the

single-factor selectivity model have not been altered when more

sophisticated models are applied.

Ippolito (1989)31

conducted a research to analyze the efficiency in

capital markets when information is costly to obtain. Sample of 143

mutual funds were reported in the 1965 edition of Wiesenberger. The

analysis was done for the period of 19651984. Ippolito (1989) employed

CAPM model and made a comparison of results to those reported in

Jenson (1968). The results showed that Risk-adjusted returns in the

mutual fund industry, net of fees and expenses, were comparable to

31 Ippolito (1989) Efficiency with Costly Information: A Study of Mutual Fund Performance, 1965-

1984, The Quarterly Journal of Economics, 104, 1, 1-23.


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returns available in index funds. Results also indicated that portfolio

turnover and management fees were unrelated to fund performance. The

researcher concluded that mutual funds with higher turnover fees and

expenses, earn rates of return sufficiently high to offset the higher

charges. Research also concluded that the mutual funds were efficient in

the trading and information-gathering activities.

Jagadeesh and Narasimhan (1990)32

have developed a new

approach for testing asset pricing model . The principal advantage with

the approach is that it does not require specification of a particular form

for the alternate hypothesis. It allows use of individual for the alternate

hypothesis. It allows use of individual security data without aggregation

into portfolios which in general should increase the power of the tests. A

method for comparing the specifications of different asset pricing models,

which could be non-tested, is also proposed. This approach is used to test

the capital asset pricing model, a size based returns model and the

arbitrage pricing theory. In all these tests, the joint hypothesis of the

adequacy of the asset pricing model and market efficiency are rejected.

All of these tests indicate pronounced short term return reversal effect

which appears to be related to asset specific returns. Additional tests

further support such a conclusion.

32Jagadeesh, Narasimhan, "Evidence of Predictable Behavior of Security Returns", Journal of Finance,

July 1990.


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Santini, Donald Louis (1990)33

made an attempt to measure the

competitive success the mutual funds by assessing the ability to attract

new money. The main objective of this study is to identify those factors

that will explain the flow of new money into and out of common stock

mutual funds. This current research investigates the flow of new money

on three levels. The first level analyzes the flow of new money to the

entire mutual fund industry. The second level analyzes the flow of new

money after the mutual funds have been grouped according to their risk

and return characteristics. The third level analyzes the flow of new money

to individual mutual funds. The analysis is conducted on three levels

because the factors that are helpful in explaining the flow of funds on one

level may not be helpful on one, or both, of the other levels. The variables

included to explain the flow of new money are characterized as follows:

general environmental variables; risk objective classification variables;

and fund specific variables.

A research was conducted by Cumby and Jack (1990) 34 to

compare the performance of internationally diversified mutual funds with

international equity index and Morgan Stanley Index for the United

States. In this study a sample of fifteen U.S.-based internationally

33Donald Louis, "An Analysis of the Flow of New Money to Open-ended Mutual Funds", Dissertation

submitted in Boston University, Graduate School of Management, May 1990.

34Cumby and Jack (1990), Evaluating the Performance of International Mutual Funds. Journal of

Finance 45, 2, 497-521.


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diversified mutual funds between 1982 and 1988 was used. The

performance was then compared with the help of Jensen (1968) measure

and Positive Period Weighting Measure. The results concluded that the

performance of funds individually or as a whole was not higher than the

performance of international equity index. The authors also examined the

performance of the funds relative to the Morgan Stanley index for the

United States and found some evidence that the funds outperform the

U.S. index.

In 1992, Pinto and Jerald35

have incorporated three empirical

studies investigating the informational efficiency of the U.S. capital

markets. The evidence of each study is consistent with a traditional view

of market efficiency. The first paper examines forecasting ability and

performance of balanced mutual funds contemporaneously available to

investors, between 1965 and 1985, using quarterly asset composition

information in Wiesenberger Management Results. This first study to

apply asset information directly to mutual fund performance evaluation

finds that (1) asset allocation decisions exhibited insignificantly positive

success overall in forecasting the sign of the stock-bond relative return;

the distribution of successes over time did not exhibit clustering (contra

35Pinto and Jerald. E., Investment Management and Performance Evaluation (Portfolio Theory),

Unpublished Ph.D Thesis, Graduate school of Business Administration, New York University, 1992.


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Hendricks et al. (1988)36

); (2) macro forecasting performance was

natural for funds as a group; ability to forecast interest rates was

outweighed by inferior forecasting with respect to common stocks; (3)

the typical fund did not present the opportunity for a marginal mean-

variance improvement over a buy-and-hold investment in any of several

benchmark portfolios.

The second study relates the returns on 236 domestic equity mutual

funds over a period of 10 years between 1972 and 1982. To a return

generating equation incorporating the set of macroeconomic factors

developed by Burmeister and Wall (1986)37and Burmeister, Wall and

Hamilton (1986)38

. The focus is on the attribution of performance to

information about specific economic factors. This is of interest to

efficient markets theory as mutual fund managements expend substantial

resources in macroeconomic forecasting. Using transmitted effects

Mundlak (1978)39

regressions, we conclude that (1) adjustments in factor

exposure typically did not contain information about future factor values;

(2) the non-stock factors, in particular unanticipated inflation, are more

important than the market factor in explaining fund returns.

36Hendricks et.al. (1988) quoted Pinto and Jerald Thesis (Ph.D.) 1992.

37Burmeister and Wall (1986) Thesis (Ph.D.), 1992.

38

Wall and Hamilton (1986) Thesis (Ph.D.), 1992.

39Mundlak (1978) Thesis (Ph.D.), 1992.


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Grinblatt and Sheridan (1992)40

conducted a research to analyze

whether mutual fund performance relates to past performance. For this

purpose a sample of 279 funds was taken. Study divided the sample into

two five year sub periods and calculated the abnormal returns of each

fund for each five year sub period. Similarly the slope coefficient of

abnormal returns was computed in a cross-sectional regression. The

results indicated a positive persistence in mutual fund performance and

fund managers were able to earn abnormal returns. Therefore study

concluded that the past performance of a fund provides useful

information for investors who were considering an investment in mutual

funds.

Possibly the most compelling evidence is presented by Fama and

French (1992)41

. They find that book-to-market equity is the most

significant explanatory variable for predicting security returns, and that

portfolios with a low market-to-book value ratio have higher returns than

predicted by CAPM. They find that the combination of market-to-book

value and size explains returns and that beta is insignificant in a

regression that includes all three variables. This multi-beta approach is

40Grinblatt and Sheridan (1992), the Persistence of Mutual Fund Performance, The Journal of Finance,

47, 5, 1977-1984.

41Fama and French, "The cross-section of Expected stock returns", Journal of Finance, June,1992.


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somewhat related to the work or Ross (1976)42

who developed the

Arbitrage Pricing Theory (APT). They use the statistical procedure of

factor analysis to determine the relationship between factors thought to

effect security returns and actual returns APT is a rival CAPM and its

treatment is beyond the scope of this study. However, there is increasing

support for theories other than a single factor CAPM. The issue of

whether non-fundamental factors such as investor fads or sentiment affect

stock prices has long been a contentious issue in financial economics.

Recently, it has been proposed that the closed-end fund discount puzzle

and the small firm effect may be related to the actions of individual

investors who trade based on sentiment. Empirical studies that show that

movements in closed-end fund discounts and small firm prices are

correlated have been interpreted as evidence that investor sentiment

affects stock prices.

A research was conducted by Martin et al. (1993)43

to examine the

performance of bond mutual funds. Samples of bond fund: first sample

was designed to eliminate survivorship bias and was comprised of the 46

non-municipal bond funds for the 10-year period from the beginning of

42 Rass, "The Arbitrage Theory of Capital Asset Pricing'', Journal of Economic Theory, December,

1976.

43Martin et al. (1993), 'Efficiency with costly information: A reinterpretation of evidence from

managed portfolios', Review of Financial Studies, 6, 1, 1-22.


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1979 to the end of 1988. The second sample consisted of all bond funds

that existed at the end of 1991. Researcher used linear and nonlinear

models in order to examine the two samples. The results showed that

bond funds underperform relevant indexes post expenses.

Swaminathan and Bhaskaran (1994)44

made on attempt to focus

on the implications of individual investor behavior for the pricing of

close-ended funds and small firms. Specifically, they developed a two

security, noisy rational expectations model of closed-end funds and

compare its predictions to that of a model of investor sentiment. The

rational model shows that the estimation errors of rational but imperfectly

informed small, individual investors can give rise to average discounts.

However, discounts cannot track time variation in expected returns

induced by mean reversion in small investor estimation errors. In

contrast, in a model of investor sentiment, discounts can track time

variation in expected returns induced by mean reversion is small investor

sentiment. This implies that discounts can forecast stock returns either if

they are a proxy of investor sentiment or if they are a proxy of some

fundamental factor.

44

Swaminathan and Bhaskaran, "The Implications of Individual Investor Behavior for the Pricing ofClose-Ended Funds and Small firms", Unpublished Ph.D Thesis, submitted to University of California,

1974.


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Their empirical tests examine the time series implications of the

two models. The results indicate that discounts forecast small firm

returns. They also show that the forecasting power of discounts is not

related to that of any known fundamental forecasting variable. This

evidence provides support for the investor sentiment explanation of the

pricing of closed-end funds and small firms, and suggests that there may

be sentiment related variation in small firm expected returns.

Malkiel (1995)45

conducted a research to analyze the performance

of equity mutual funds for the period 1971 to 1991. For this purpose

study involved a data set that included the returns from all mutual funds

in existence in each year of the period. After analyzing the returns from

all funds he found that mutual funds underperformed the market.

Survivorship bias was considered to be the important part of the analysis.

Study also examined the fund returns in the context of the capital asset

pricing framework and neither found any evidence of excess return nor

observed any risk return relationship stated by the capital asset pricing

model. Study concluded that it was better for the investors to purchase a

low expense index fund than to select an active fund manager.

45Malkiel (1995), 'Returns from investing in equity mutual funds 1971 to 1991', Journal of Finance, 50,

2, 549-572.


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The study by Lee,Sunghoon in (1995)46

makes three contributions

to the literature on the evaluation of mutual fund performance. First, it

evaluates various empirical models of the bond return generating process

and suggests new benchmarks that are the most appropriate for evaluating

the performance of managed bond portfolios. Second, it provides

thorough empirical evidence concerning the performance of bond mutual

funds and examines the sensitivity of performance inferences to

benchmark choice. Third, it analyzes the cross-sectional and inter-

temporal behavior of performance measures to determine the relationship

between performance and various fund characteristics. The

appropriateness of benchmarks is tested in both the specialized context of

mean-variance efficiency and in the more general context of goodness-of-

fit comparison. Among the six proposed benchmarks, the two-factor

model, consisting of the composite bond index and six-month Treasury

bill index, and the three-factor model, consisting of the composite bond

index, are the most appropriate for performance evaluation of bond

mutual funds. They find little evidence that the managers of bond fund as

a class provide superior performance after accounting for expenses

relative to various benchmark returns. While the average Jensen alphas

across benchmarks are predominantly negative in both the full sample

period and in the first sub-period, bond mutual funds exhibit better

46Lee, Sunghon, "The evaluation of Bond Mutual Fund Performance", Unpublished Ph.D, Thesis

submitted to State University of New york, Buffalo, 1995.


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performance with a considerable decrease in the number of funds with

significantly negative Jensen alphas during the second sub-period

spanning from 1984 to 1989.

Another study by Prather and Larry Joseph (1995)47

reexamines

performance evaluation of managed portfolios. Past measures of portfolio

evaluation such as the Sharpe, Treynor, and Jensen measures are subject

either to the inability to rank performance based on statistical

significance, or are dependent on both a single factor CAPM return

generating process and the selected market portfolio. Recent studies show

performance ranking is sensitive to the selection of the market proxy

when the security market line is used to evaluate performance.

Additionally, CAPM based measures that appeared to work well in the

1960's no longer appear to function effectively. Many anomalies to

CAPM have been documented since the 1970's and recently, Fama and

French (1992)48

declared the CAPM beta to be dead.

47Prather, Larry Joseph, "New Paradigms for Evaluating Performance and Performance Persistency of

Domestic and Globally Diversified Portfolios", Unpublished Ph.D Thesis submitted in Old Dominion

University.

48

Fama and French, "The Cross-section of Expected Stock Returns", Journal of Finance, December1984.


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Cai et al. (1996)49

evaluated the performance of Japanese open

type equity funds from 1981 to 1992. For this purpose a sample of 800

open-type mutual funds run by 9 management companies was taken. Two

benchmarks (value-weighted single-index benchmark and three-factor

benchmark) were used in the analysis. This research used Jensen

Measure, Positive Period Weighting (PPW) Measure and Conditional

Jensen Measure in order to evaluate the performance of these funds. The

results showed that value-weighted and equal-weighted portfolios of 800

mutual funds underperform the single-index benchmark by approximately

7.0% and 6.0%. The results also showed that most of the funds were

inclined to invest more in large stocks.

Otten and Dennis (1999)50

analyzed the performance of European

mutual funds from 1991 through December 1998. Study also investigated

the performance of fund managers along with the influence of fund

characteristics on risk-adjusted performance. For this purpose a sample of

506 funds was taken and 4-factor model was used. The results indicated

that the European mutual funds especially small cap funds were able to

add value and 4 out of 5 countries exhibit significant outperformance at

an aggregate level. The results also revealed positive relation between

49Cai et al. (1997), The performance of Japanese mutual funds, The Review of Financial Studies, 10, 2,

237-273.

50Otten and Dennis (1999), European mutual fund performance, European Financial Management, 8,

1, 75-101.


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risk-adjusted return and fund size and negative relation between risk-

adjusted and funds' expense ratio.

Zheng, Lu, (1999)51

Yale university Contributed three essays on

Investment cash flows regarding mutual funds, Stock prices. These essays

study cash flow related behavior of different classes of investors and

examine possible market impact of these investment cash-flows. The first

essay looks into open-end equity mutual fund shareholders' fund selection

ability by analyzing the performance predictability of investors' cash-

flows. Using a large sample of equity funds, the researcher could notice

that funds that receive more money subsequently perform significantly

better than those that lose money. This effect is short-lived and is largely

but not completely explained by a strategy of betting on winners. In the

aggregate, there is only marginal evidence that funds that receive more

money subsequently beat the market. However, it is possible to earn

significant positive abnormal returns by using the cash-flows information

for small funds. The second essay examines the relation between stock

prices and cash-flows from different investment sectors. Using long-term

data on stock market and investment cash-flows, it was identified that

there are some investment sectors which can effectively set stock prices.

These sectors include mutual funds, foreign investors, and pension funds.

51 L.U. Zheng, "Investment Cash Flows Regarding Mutual Funds, Stock Prices" Unpublished Ph.D

Thesis submitted in Yale University, 1999.


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Further, the study examined the economic significance of the possible

market impact of these sector cash-flows by studying the

contemporaneous relation between stock market returns and the sector

cash-flows. The researcher found no Granger-causality between quarterly

stock market returns and the sector cash-flows in either direction. By

studying the response of the sector cash-flows to shocks in stock returns

over time, the researcher observed a much longer memory for the mutual

fund sector than for any other sectors in the economy. The third essay

examines the relation between stock market volatility and cash-flows

from different investment sectors. It is observed that cash inflows of

close-end funds are positively related to contemporaneous upward

volatility, and that cash outflows of foreign investors and mutual funds

are positively related to both upward and downward volatility. The VAR

analysis indicates that unexpected cash outflows of foreign investors and

mutual funds are positively correlated with contemporaneous downward

volatility of the stock market. In the long run, household investors pursue

a volatile upward market while mutual funds and other institutional

investors are averse to high volatility in a downward market.

Redman (2000)52

analyzed the risk adjusted returns for five

portfolios of international mutual funds. The study was conducted for

52Redman (2000) the Performance of Global and International Mutual Funds, Journal of Financial and

Strategic Decisions 13, 1, 75-85.


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three periods: 1985-1994, 1985-1989, and 1990-1994. The performance

was measured by using Treynor (1965) Index Sharpe (1966)'s Index and

Jensen's Alpha and comparison was made with the U. S. market. Results

showed that under Sharpe (1966)'s and Treynor (1965) indices the

performance of portfolios of international mutual funds was higher than

the U. S. market from 1985-1994 and 1985-1989. On the other hand

performance of U.S equity portfolio and the market index was higher

than global portfolios from 1990-1994.

Stehle and Olaf (2001)53

conducted a research to evaluate the

open-ended mutual funds risk-adjusted performance. Study used a data

set that included all German funds sold to the public in 1972. The

research analyzed covers the time period of 1973 to 1998. DAX, which

included the 30 largest German stocks and DAX100, which included the

100 largest German stocks were used as benchmarks for comparison.

First of all researchers examined the rates of return of individual funds

with the help of Sharpe (1966) and Jensen measures and then applied the

same measures to evaluate the unweighted average rates of return of all

funds. In case of the rates of return of individual funds, results showed

that the funds underperform the appropriate benchmarks by

approximately 1.5 % per year. On the other hand underperformance was

53Stehle and Olaf (2001), The Long-Run Performance of German Stock Mutual Funds, Working

Paper, Humboldt-Universitat zu Berlin.


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reduced by 40 % in case of unweighted average rates of return. Study also

concluded that the large German stock mutual funds, on the average,

performed better than the small ones.

A study was conducted by Otten, and Mark (2002)54

to compare

the performance of European mutual fund industry with performance of

United States fund industry. Sample of 506 European open-ended mutual

funds and 2096 American open-ended mutual funds was taken from

January 1991 to December 19979. Study was restricted the sample to

purely domestic equity funds with at least 24 months of data. Results also

indicated that European mutual funds had on average a better

performance than the American counterparts and that the small cap

mutual funds in both Europe and the United States outperformed the

benchmark and all other mutual funds.

Noulas, John and John (2005)55

evaluated the risk adjusted

performance of Greek equity funds during the period 1997-2000. This

study is based on weekly data for equity mutual funds and includes 23

equity funds that existed for the whole period under consideration.

Mutual funds were ranked on the techniques used by Treynor (1965),

54Otten, and Mark (2002), A Comparison between the European and the U.S. Mutual Fund Industry,

Managerial Finance, 28, 1, 1434.

55Noulas, John and John (2005), Performance of Mutual Funds. Managerial Finance, 31, 2, 101-112.


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Sharpe (1966) and Jensen. Results showed positive returns of the stock

market for the first three years and negative returns for the fourth year.

The results also indicated that the beta of all funds is smaller than 1 for

four-year period. The authors concluded that the equity funds have

neither the same risk nor the same return. The investor needs to know the

long-term behavior of mutual funds in order to make the right investment

decision.

Leite and Cortez (2009)56

conducted a research to analyze the

impact of using conditioning information in evaluating the performance

of mutual funds. For this purpose two different samples of Portuguese-

owned open end equity funds were built, over the period of June 2000 to

June 2004. The first sample contained surviving 24 funds (10 National

funds and 14 European Union funds) at the end of June 2004. While the

second sample included all surviving and 20 non-surviving funds during

the sample period. Both conditional and unconditional models were used

to evaluate the performance. The results of unconditional model indicated

that the performance of National funds was neutral while the performance

of European Union funds was negative. On the other hand conditional

models suggested that conditional betas (but not alphas) are time-varying

and dependent on the dividend yield variable.

56Leite and Cortez (2009), "Conditional Performance Evaluation: Evidence from the Portuguese

Mutual Fund Market", Working Paper, University of Minho.


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Boudreaux and Suzanne (2010)57

conducted a study to examine

the risk adjusted returns of international mutual funds for the period of

2000-2006. For this purpose a sample of ten portfolios of international

mutual fund was taken and risk-adjusted performance was calculated by

using Sharpe (1966)'s Index of Reward to Variability ratio. US market of

mutual funds was taken as the benchmark. The results showed that the

performance of nine out of ten of the international mutual fund was

higher than the U.S. market. Those portfolios which contained only U.S

stock mutual funds underperform on a risk adjusted the funds that

contained all international mutual funds. The authors concluded that

Investors may not fully take advantage of possible portfolio risk

reduction and higher returns if international mutual funds were excluded.

Arugaslan and Ajay (2012)58

examined the risk-adjusted

performance of US-based international equity funds from 19942003. The

analysis was done for five-year period 1999-2003 and ten-year period

1994-2003. For this a sample of 50 large US-based international equity

funds was taken and a new method of measurement Modigliani and

Modigliani (M squared) was applied. The performance was compared

with both domestic and international benchmark indices. The results

57Boudreaux and Suzanne (2010), Empirical Analysis of International Mutual Fund Performance,

International Business & Economics Research Journal, 6, 19-22

58 Arugaslan, and Ajay (2012), Evaluating large US-based equity mutual funds using risk-adjusted

performance measures, International Journal of Commerce and Management, 17, 1/2, 624.


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showed that the risk has great impact on the attractiveness of Funds.

Higher return funds may lose attractiveness due to higher risk while the

lower return funds may be attractive to investors due to the lower risk.

Dietze, Oliver and Macro (2013)59

conducted a research to

evaluate the risk-adjusted performance of European investment grade

corporate bond mutual funds. Sample of 19 investment-grade corporate

bond funds was used for the period of 5 years (July 2000 - June 2005).

Funds were evaluated on the basis of single-index model and several

multi-index and asset-class-factor models. Both maturity-based indices

and rating based indices were used to account for the risk and return

characteristics of investment grade corporate bond funds. The results

indicated that the corporate bond funds, on average, underperformed the

benchmark portfolios and there was not a single fund exhibiting a

significant positive performance. Results also indicated that the risk-

adjusted performance of larger and older funds, and funds charging lower

fees was higher.

59

literature review of mutual funds 23.10.14

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