Mutual funds exploit through higher fees investors who chase ‘stale returns’
Cambridge (PRWEB UK) 20 February 2015 -- Mutual funds are exploiting unsophisticated mutual fund investors who chase “stale returns” because they’re unable to distinguish between positive new results and the dropping of poor older results from the relevant reporting period, says research co-authored at Cambridge Judge Business School.
Funds report performance based on a “holding period return” (HPR) of a standard duration – typically one, three, five or 10 years – so fund performance in that HPR can improve through good performance in a fresh new quarter or the automatic dropping of poor results from a quarter at the beginning of that HPR. The latter scenario can make a fund appear healthier than its current performance.
Fund managers “specifically cater to and exploit” investors who appear unable to discern these different factors by targeted advertising of fund “improvement” caused by the mechanical dropping of poor stale returns, and then linking fee increases to the resultant increased demand, the research found.
“Either due to naivety or limited attention, investors misinterpret changes in HPRs,” the study found, and fund managers are “taking advantage” of these “unsophisticated investors.”
“Our study found clear evidence of opportunistic behaviour by mutual fund managers,” said co-author Raghu Rau of Cambridge Judge Business School. “Investors disproportionately invest in funds which improve performance due to stale returns dropping out, and fund managers exploit this by aggressively marketing these funds and then aligning fee increases to the artificially heightened demand for such funds.”
“The study paints a picture that’s not very pretty: mutual funds are using uninformative information in the form of stale returns to convince investors that they are buying quality or high-performing funds, when the current performance of these funds might be far less impressive,” said Rau.
The paper was co-authored by Blake Phillips of the University of Waterloo in Canada, Kuntara Pukthuanthong of the University of Missouri, and Raghu Rau, Sir Evelyn de Rothschild Professor of Finance at Cambridge Judge Business School.
The study – Past performance may be an illusion: Performance, flows and fees in mutual funds – has been accepted for publication by the journal Critical Finance Review, and recently was named best paper in investments at the annual meeting of the Southern Finance Association in the U.S.
The study looks at U.S. mutual funds in the period 1992 to 2010. While availability of mutual fund information “expanded dramatically” during this period, most mutual fund investors are individuals (89% of U.S. mutual fund assets were held by households in 2012) who are “overwhelmed” by the sheer volume of information and thus “gravitate to information that is presented in a salient, easily processed form” – like advertising of specific funds and their HPRs.
To access the study please follow the link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2168768
Charles Goldsmith, Cambridge Judge Business School, http://www.jbs.cam.ac.uk, +44 1223339608, [email protected]
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