Staying the Course: Mutual Fund Investment Style Consistency and Peformance Persistence

1
Staying the Course Mutual Fund Investment Style
Consistency and Performance Persistence
Keith C. Brown The University of Texas W. Van
Harlow Fidelity Investments Federal Reserve
Bank of Atlanta Financial Markets
Conference April 15, 2004
2
Research Premise
Does Investment Style Consistency Impact
Performance?
Lower Style Consistency
Higher Style Consistency
Cap Small to Large ()
Cap Small to Large ()
Value to Growth ()
Value to Growth ()
3
Why Style Consistency Might Matter

• Fund Outflows Due to Style Drift
• Inability of Plan Sponsors to Identify Managers
  Style
• Higher Consistency Lower Turnover?
• Possibility of Lower Transaction Costs and
  Expense Ratios
• Style Timing Might be a Losers Game
• Analog to Difficulty of Successful Tactical Asset
  Allocation
• Style Consistency as a Possible Signal of
  Superior Manager Performance

4
Simple Evidence
Average Annual Return (1991-2000)
Peer Group
Style Consistency
Lower
11.10
Large Value
Higher
13.05
Large Blend
Lower
16.69
Higher
20.04
Lower
18.55
Higher
19.86
Lower
17.30
Higher
13.58
Lower
12.95
Higher
12.86
Lower
13.90
Higher
15.44
Lower
15.83
Higher
16.65
Lower
14.28
Higher
15.62
Lower
12.78
Higher
14.21
5
Complicating Factors
Higher Returns for More Style Consistent Funds
Median Annual Fund Return (1991-2000)
Peer Group
Style Consistency
Median Turnover
Median Expense Ratio
Lower
11.10
1.22
Higher
13.05
1.02
Large Blend
Lower
16.69
1.25
Higher
20.04
0.93
Lower
18.55
1.36
Higher
19.86
1.07
Lower
17.30
1.40
Higher
13.58
1.16
Lower
12.95
1.41
Higher
12.86
1.23
Lower
13.90
1.40
Higher
15.44
1.29
Lower
15.83
1.39
Higher
16.65
1.15
Small Blend
Lower
14.28
1.50
Higher
15.62
1.12
Lower
12.78
1.46
Higher
14.21
1.33
6
Complicating Factors
Higher Returns for More Style Consistent Funds
Median Annual Fund Return (1991-2000)
Peer Group
Style Consistency
Median Turnover
Median Expense Ratio
Lower
11.10
1.22
Higher
13.05
1.02
Large Blend
Lower
16.69
1.25
Higher
20.04
0.93
Lower
18.55
1.36
Higher
19.86
1.07
Lower
17.30
1.40
Higher
13.58
1.16
Lower
12.95
1.41
Higher
12.86
1.23
Lower
13.90
1.40
Higher
15.44
1.29
Lower
15.83
1.39
Higher
16.65
1.15
Small Blend
Lower
14.28
1.50
Higher
15.62
1.12
Lower
12.78
1.46
Higher
14.21
1.33
7
Past Literature

• Investment Style Appears to Matter
• Fund Objectives McDonald (JFQA, 1974) Malkiel
  (JF, 1995)
• Security Characteristics Basu (JF, 1977) Banz
  (JFE, 1981) Fama and French (JF, 1992 JFE,
  1993)
• Style Premiums Capaul, Rawley, Sharpe (FAJ,
  1993) Lakonishok, Shleifer, Vishny (JF, 1994)
  Fama and French (JF, 1998) Chan and Lakonishok
  (FAJ, 2004) Phalippou (Working Paper, 2004)
• Style Definitions Roll (HES, 1995) Brown and
  Goetzmann (JFE, 1997)
• Style Rotation Barberis and Shleifer (JFE, 2003)
• Fund Performance Persistence
• Classic Study Jensen (JF, 1968)
• Hot Icy Hands Grinblatt and Titman (JF, 1992)
  Hendricks, Patel, Zeckhauser (JF, 1993) Brown
  and Goetzmann (JF, 1995) Elton, Gruber, Blake
  (JB, 1996), Ibbotson and Patel (Working Paper,
  2002)
• Accounting for Momentum Jegadeesh and Titman
  (JF, 1993) Carhart (JF, 1997) Wermers (2001)
• Conditioning Information Ferson and Schadt (JF,
  1996), Christopherson, Ferson, and Glassman (RFS,
  1998)
• Persistence Style Bogle (JPM, 1998) Teo and
  Woo (JFE, forthcoming)

8
Research Design
Does Style Consistency Impact Performance?

• Use alternative definitions of style consistency
• Control for other factors affecting performance
• Alpha persistence
• Expense ratio
• Turnover
• Fund size
• Active/passive management

9
Measuring Investment Style Style Consistency
Two Approaches

• Holdings-Based Measures Daniel, Grinblatt,
  Titman, and Wermers (JF, 1997)
• Pros Direct Assessment of Managers Selection
  and Timing Skills Benchmark Construction Around
  Security Characteristics
• Cons Unobservable or Observed with Considerable
  Lag
• Window Dressing Problems
• Returns-Based Measures Sharpe (JPM, 1992)
• Pros Direct Observation of Bottom Line to
  Investor Measured More Frequently and Over
  Shorter Time Intervals than Holdings
• Cons Indirect Measure of Managerial
  Decision-Making

10
Returns-Based Measures of Investment Style
Consistency

• Model Based
• Define a style factor model
• 1 R2 represents portion of return not related
  to style
• Benchmark Based
• Active Net Returns
• TE
• where P is the return periods per year

s?vP
11
Testable Hypotheses

• Hypothesis 1 Style-consistent (i.e., high R2,
  low TE) funds have lower portfolio turnover than
  style-inconsistent (i.e., low R2, high TE) funds.
• Hypothesis 2 Style-consistent funds have
  higher total and relative returns than
  style-inconsistent funds.
• Hypothesis 3 There is a positive correlation
  between the consistency of a funds investment
  style and the persistence of its future
  performance

12
Data

• Survivorship-bias free database of monthly
  returns for domestic diversified equity funds for
  the period 1988-2000
• Morningstar style classifications (large-, mid-,
  small-cap value, blend, growth)
• Mutual Fund characteristics for the period
  1991-2000 (e.g., expense ratio, turnover, total
  net assets)
• Require three years of prior monthly returns to
  be included in the analysis on any given date
• No sector funds analyze with and without index
  funds (i.e., active vs. passive management)

13
Number of Funds withThree Years of Returns
(Table 1)
Large Blend
Large Growth
Mid Value
Mid Blend
Mid Growth
Small Value
Small Blend
Small Growth
Large Value
Year
1991
135
163
118
60
47
79
25
29
42
1992
140
172
120
60
49
78
28
30
44
1993
156
184
126
65
54
78
31
30
49
1994
169
203
139
67
54
82
38
37
59
1995
215
245
178
69
62
106
47
52
78
1996
273
314
233
87
71
150
62
71
113
1997
350
382
297
102
99
183
79
97
152
1998
410
446
355
127
104
221
97
123
206
1999
504
584
425
167
125
289
121
147
262
2000
564
729
549
199
138
333
162
194
309
14
Average Fund Characteristics 1991-2000(Table 2)
Average Fund Firm Size (mm)
Average Expense Ratio
Peer Group
Average Turnover
Large Value
67.57
1.38
25,298


Large Blend
69.14
1.22
44,611


Large Growth
92.93
1.45
45,381


Mid Value
84.73
1.43
5,731


Mid Blend
79.39
1.45
6,782


Mid Growth
132.96
1.55
4,917


Small Value
61.43
1.48
643


Small Blend
82.17
1.50
1,283


Small Growth
119.89
1.64
1,057


15
Methodology

• Use two alternative returns-based definitions of
  style consistency
• Goodness-of-fit from a multivariate factor model
  (i.e., R2)
• Tracking error relative to peer-group specific
  benchmarks
• Evaluate the impact of style consistency on
  performance by using a tournament-based
  methodology (Brown, Harlow, Starks (JF, 1996))
• Relative performance within a peer group is the
  focus
• Avoids the usual model specification issues
• Controls for cross-sectional differences in
  consistency measures

16
Methodology

• Multivariate Performance Attribution Model
• Factor Models
• EGB Four Factor - Elton, Gruber and Blake (JB,
  1996)
• Modified EGB with Five Factors (adding EAFE
  factor)
• FF Three Factors - Fama and French (1993)
• FFC Four Factors - Carhart (1997)
• Use R2 and alpha from the model

17
Methodology (Figure 1)
Examples from Multivariate Factor Model
R2 0.92
R2 0.78
Cap Small to Large ()
Cap Small to Large ()
Value to Growth ()
Value to Growth ()
18
Methodology (Table 3)
19
Methodology
Evaluate Tournament Performance
Estimate Model
Time
36 Months
3 Months (12 Months)

• Use past 36 months of data to estimate model
  parameters
• Evaluate performance in tournament
• Standardized returns within each peer group on a
  give date to allow for time-series and
  cross-sectional pooling
• Peer rankings
• Above median performance
• Roll the process forward one quarter (one year)
  and estimate all parameters again, etc.

20
Univariate Analysis (Table 4)
Correlation with R² FFC Four-Factor
Model (1991-2000)
21
Multivariate Analysis (Table 5A)
3-Month Future Returns (1991-2000)

FFC Four-Factor Model
FF Three-Factor Model
Parameter
Parameter
Prob
Prob
Estimate
Estimate
Variable
Intercept
0.000
1.000
1.000
0.000
Alpha
0.058
0.000
0.011
0.011
Consistency (R²)
0.034
0.000
0.000
0.030
Turnover
0.032
0.000
0.000
0.033
Expense Ratio
(0.068)
0.000
0.000
(0.082)
Assets
(0.011)
0.012
0.093
(0.008)
22
Multivariate Analysis (Table 5B)
12-Month Future Returns (1991-2000)

FFC Four-Factor Model
FF Three-Factor Model
Parameter
Parameter
Prob
Prob
Estimate
Estimate
Variable
Intercept
0.000
1.000
1.000
0.000
Alpha
0.060
0.000
0.000
0.038
Consistency (R²)
0.081
0.000
0.000
0.077
Turnover
0.060
0.000
0.000
0.062
Expense Ratio
(0.134)
0.000
0.000
(0.145)
Assets
(0.021)
0.022
0.038
(0.019)
23
Fama-MacBeth Cross-Sectional Analysis

• Use past 36 months of data to estimate model
  parameters
• Run a sequence of cross-sectional regressions of
  future performance against fund characteristics
  and model parameters (alpha and R2 )
• Average the coefficient estimates from
  regressions across the entire sample period
• T-statistics based on the time-series means of
  the coefficients

24
Fama-MacBeth Cross-Sectional Analysis(Table 6)
3-Month Future Returns (1991-2000)

FFC Four-Factor Model
FF Three-Factor Model
Parameter
Parameter
Prob
Prob
Estimate
Variable
Estimate
Alpha
0.087
0.000
0.029
0.040
Consistency (R²)
0.067
0.000
0.000
0.068
Turnover
0.001
0.970
0.970
0.001
Expense Ratio
(0.099)
0.000
0.000
(0.099)
Assets
0.018
0.030
0.030
0.018
25
Multivariate Analysis (Table 7)
Summary of Style Consistency Parameters
for Individual Style Groups (12-Month Future
Returns)




_










Note Significant at the 10 level 5
level 1 level
26
Logit Analysis for Above-Median Performance
(Table 8)
12-Month Future Returns FFC Four-Factor Model
(1991-2000)
FF Three-Factor Model
FFC Four-Factor Model
Parameter
Parameter
Estimate
Variable
Prob
Prob
Estimate
Intercept
0.005
0.788
0.821
0.004
Alpha
0.048
0.029
0.039
0.043
Consistency
0.115
0.000
0.000
0.115
Turnover
0.093
0.000
0.000
0.098
Expense Ratio
(0.194)
0.000
0.000
(0.200)
(0.020)
0.304
Assets
(0.022)
0.257
ConsistencyAlpha
0.008
0.548
0.064
0.024
27
Logit Analysis for Above-Median Performance
(Table 9A)
Probability Implications for the FFC Four-Factor
Model Assuming average characteristics for
expense ratio, turnover and assets (1991-2000)



Consistency (RSQ)



Standard Deviation Group
-2 (Low)

-
1

0

1

2
(High


(High)
Low)











-
2 (Low)

0.4467

0.4631

0.4796

0.4962

0.5127

0.0660










-
1

0.4453

0.4678

0.490
3

0.5129

0.5355

0.0902










ALPHA

0

0.4440

0.4725

0.5010

0.5296

0.5580

0.1140








1

0.4427

0.4771

0.5118

0.5463

0.5804

0.1377








2 (High)

0.4414

0.4818

0.5225

0.5628

0.6024

0.1610








(High


-
0.0053

0.0187

0.0429

0.0666

0.0897


Low)


28
Logit Analysis for Above-Median Performance
(Table 9B)
Probability Implications for the FFC Four-Factor
Model Assuming average characteristics turnover
and assets but 2 std for expense
ratio (1991-2000)



Consistency (RSQ)



Standard Deviation Group
-2 (Low)

-
1

0

1

2
(High


(High)
Low)











-
2 (Low)

0.5464

0.5628

0.5790

0.5951

0.6110

0.0646










-
1

0.5451

0.5674

0.5895

0.6111

0.6324

0.0873










ALPHA

0

0.5438

0.5720

0.5998

0.6269

0.6533

0.1095








1

0.5425

0.5766

0.6100

0.6425

0.6736

0.1312








2 (High)

0.5412

0.5812

0.6202

0.6577

0.6933

0.1522








(High


-
0.0053

0.0184

0.0412

0.0626

0.0824


Low)


29
Active versus Passive
Multivariate Analysis Three-Month Future
Returns (1991-2000)

Excluding Index Funds
All Funds
Parameter
Parameter
Prob
Prob
Estimate
Estimate
Variable
Intercept
0.000
1.000
1.000
0.000
30
Alternative Consistency Measure
Tracking Error as a Measure of Style Consistency

• Analysis using tracking error produces virtually
  identical results

31
Trading Strategies
Returns of Low and High Expense Ratio
Quintiles (1991-2000)
5.00
4.50
Lo EXPR
4.00
Lo EXPR 15.58 Hi EXPR 13.44
Hi EXPR
3.50
Annual Return Difference 2.14
3.00
Growth of a 1
2.50
2.00
1.50
1.00
199012
199106
199112
199206
199212
199306
199312
199406
199412
199506
199512
199606
199612
199706
199712
199806
199812
199906
199912
200006
Date
32
Trading Strategies (Figure 2A)
Style Consistency Implications for Returns of Low
and High Expense Ratio Quintiles (1991-2000)
5.00
Hi RSQ Lo EXPR
4.50
Lo EXPR
4.00
Hi RSQ Lo EXPR 15.79 Lo RSQ Hi EXPR 13.10
Hi EXPR
3.50
Lo RSQ Hi EXPR
Annual Return Difference 2.69
3.00
Growth of a 1
2.50
2.00
Consistency Premium 0.55
1.50
1.00
199012
199106
199112
199206
199212
199306
199312
199406
199412
199506
199512
199606
199612
199706
199712
199806
199812
199906
199912
200006
Date
33
Trading Strategies
Returns of Low and High Expense Ratio and Alpha
Quintiles (1991-2000)
199012
199106
199112
199206
199212
199306
199312
199406
199412
199506
199512
199606
199612
199706
199712
199806
199812
199906
199912
200006
Date
34
Trading Strategies (Figure 2B)
Style Consistency Implications for Returns of Low
and High Expense Ratio and Alpha
Quintiles (1991-2000)
5.00
Hi RSQ Lo EXPR Hi ALPHA
4.50
Lo EXPR Hi ALPHA
Hi RSQ Lo EXPR Hi ALPHA 16.08 Lo RSQ Hi
EXPR Lo ALPHA 10.14
4.00
3.50
Annual Return Difference 5.94
Hi EXPR Lo ALPHA
3.00
Growth of a 1
2.50
Lo RSQ Hi EXPR Lo ALPHA
2.00
1.50
Consistency Premium 2.00
1.00
199012
199106
199112
199206
199212
199306
199312
199406
199412
199506
199512
199606
199612
199706
199712
199806
199812
199906
199912
200006
Date
35
Consistency Premiums
Consistency Premiums by Style Groups
0.85
1.89
3.07
0.19
0.54
2.40
4.60
7.16
(1.80 )
36
Conclusion

• Funds with more style consistency within a peer
  group tend to have better performance, ceteris
  paribus, during the sample period
• Findings robust with respect to two alternative
  definitions of consistency (and four factor
  models for one definition of consistency)
• Results are not related to active/passive
  management issues
• Style consistency effect appears to be separate
  from past alpha and expense ratios in explaining
  future performance
• Results are robust within sample period and
  across fund types
• Although not reported, analysis of performance
  back to 1981 (not entirely survivorship-bias
  free) produces identical results to the 1991-2000
  analysis

37
Extensions and Implications

• Need to Extend Analysis through 2003 Same
  Behavior in Down Markets?
• Consistency as a Signal of Persistence Easier
  to Identify Good Managers?
• Consistency and Governance Manager Evaluation
  Relative to Peer Group Manager Compensation
  Single vs. Team-Managed Funds
• Consistency and Regulation Easier to Assess
  Whether Fund Prospectus Objectives and
  Constraints are Satisfied?