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The Mutual Fund Industry Worldwide: Explicit and Closet Indexing, Fees and Performance. Miguel Ferreira (Nova SBE) Martijn Cremers (Yale University) Pedro Matos (University of Virginia – Darden) Laura Starks (University of Texas – Austin) Inquire Seminar – March 2012. Motivation.

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the mutual fund industry worldwide explicit and closet indexing fees and performance

The Mutual Fund Industry Worldwide: Explicit and Closet Indexing, Fees and Performance

Miguel Ferreira (Nova SBE)

MartijnCremers (Yale University)

Pedro Matos (University of Virginia – Darden)

Laura Starks (University of Texas – Austin)

Inquire Seminar – March 2012

motivation
Motivation
  • Few papers on mutual fund industry worldwide
    • Khorana, Servaes and Tufano (2005, 2009) study industry size and fees
    • Ferreira, Keswani, Miguel and Ramos (2010, 2011) study performance and flows
  • Passive funds have become an increasingly popular investment vehicle in recent times
value of active mutual fund management
Value of Active Mutual Fund Management
  • Against
    • Sharpe (1966), Jensen (1968), Gruber (1996), French (2008), Fama and French (2010),…
    • Average after-fee performance of actively managed funds is inferior to that of index funds
  • But the most “active” funds create value
    • Grinblatt and Titman (1989, 1993), Kacperzyck, Sialm and Zheng (2008), Cremers and Petajisto (2009),…
research question
Research Question
  • Passive funds (index funds and ETFs)
    • Low-cost alternative to actively-managed funds
    • Increase competitive pressure on actively managed funds
  • Effect of market share of passive funds on industry levels of competition and efficiency
    • Product differentiation: degree of “activeness”
    • Price paid for active management: fees
    • Performance: risk-adjusted after-fee performance
these are important questions
These are Important Questions

Worldwide 2010 – only Equity Funds

$10.2 trillion in AUM = 20% of market cap

$5.7 trillion U.S.

56%

$4.5 trillion non-U.S.

44%

slide6
Data
  • Lipper Hindsight database
    • Characteristics and returns of open-end equity mutual funds
    • Fund’s primary share class
    • 21,684 funds, $10.1 trillion in AUM as of 2007
      • Includes both active and dead funds
  • Factset/Lionshares database
    • Mutual funds’ portfolio holdings
    • Coverage for > 80% of TNA in Lipper
sample
Sample
  • 10,145 funds, $7.9 trillion TNA (with holdings)
  • 30 countries of domicile:
    • 18 in Europe + 2 in North America + 10 in Asia-Pacific
  • Global, regional, country and sector funds
  • 2002-2007
type of funds active vs passive
Type of Funds: Active vs. Passive
  • Explicit indexing:
    • Index funds and index-tracking ETFs
  • Closet indexing:
    • Funds claiming to be active but whose holdings are similar to their benchmark
  • Truly active:
    • Funds that are truly active in terms of distance from benchmark holdings
explicit indexing
Explicit Indexing
  • Percentage of TNA explicitly indexed16%
    • Outside the U.S.9%
    • In the U.S.20%

91% actively managed!?

80% actively managed!?

closet indexers vs active
Closet Indexers vs. Active
  • Decompose portfolio into two parts:

Portfolio = [Index] + [Portfolio – Index]

Passive Active

  • Compare portfolio weights: fund vs. benchmark – Cremers and Petajisto (2009)
    • Fraction of portfolio that is different from benchmark
    • Between 0% and 100%
active share vs tracking error
Active Share vs. Tracking Error

Source: Cremers and Petajisto (2009)

adjustments to active share calculation
Adjustments to Active Share Calculation
  • Sum of all holdings in same company (common shares, ADRs, dual listings) to calculate portfolio weights
  • Benchmark given by “Lipper Technical Indicator Benchmark”
  • Construct benchmark weights (we do not have actual weights):
    • If there > 5 index funds/ETFs with portfolio holdings, aggregate portfolio of those funds
    • If not, aggregate portfolio of all active funds that track a given benchmark
list of
List of

Benchmark Type

active vs passive funds
Active vs. Passive Funds
  • U.S. Funds
  • Non-U.S. Funds

Closet indexing if Active Share < 60%

regression tests actively managed funds 2002 2007
Regression Tests: Actively Managed Funds 2002-2007
  • Dependent variables (fund level):
    • Product differentiation: Active share
    • Price of active management: Total shareholder cost
    • Performance: Risk-adjusted performance net of fees
  • Main independent variables:
    • Market shares of explicit or implicit indexing
      • by domicile country or country/type
      • domicile country proxy for country of sale
    • Active share
      • fund level
test 1 product differentiation
Test 1. Product Differentiation
  • Hypothesis: More explicitlyindexingin a country is related to higher degree of activeness by fund managers
  • Panel regression fund-level of Active Share
    • Explicit Indexing % TNA in passive funds in country/type
    • Closet Indexing % TNA in active funds with AS < 60% (country/type )
    • TNA, age, flows, geographical focus,…
slide19

Active share increases with explicit indexing

    • Active funds choose higher degree of product differentiation when facing competitive pressure from low-cost alternatives
  • Active share decreases with closet indexing
test 2 price of active management
Test 2. Price of Active Management
  • Hypothesis: More explicitly indexing in a country is related to lower fees for actively managed funds
    • Passive funds are low cost alternative to actively managed funds
  • Hypothesis:More closet indexing in a country is related to higher fees for actively managed funds
    • Less choice of actively managed funds for investors
test 2 price of active management1
Test 2. Price of Active Management
  • Khorana, Servaes & Tufano (2009)

Total shareholder cost (TSC)

= TER + Front-end Load/5

    • Large differences in TSC across countries
    • TSC lower in countries with stronger investor protection
    • Index funds and ETFs have lower TSC
test 2 price of active management2
Test 2. Price of Active Management
  • Cross-sectional regression of Total Shareholder Cost in 2007:
    • Active Share
    • Explicit Indexing % TNA in passive funds (country/type)
    • Closet Indexing % TNA in active funds with AS < 60% (country/type )
    • TNA, age, flows, geographical focus,…
slide25

TSC increases with Active Share

    • More active funds charge higher fees
  • TSC decreases with explicit indexing and increases with closet indexing
    • Active funds charge lower fees when facing competitive pressure from low-cost alternatives
slide26

Test 3. Returns to Active Management

  • Hypothesis:the most “active” funds deliver higher performance
    • Competitive pressure by passive funds makes active funds choose higher degree of activeness and achieve higher after-fees performance
  • Risk-adjusted performance measures:
    • Benchmark-adjusted returns= fund return – benchmark return
    • 4-factor alphas from benchmark-adjusted returns
      • Regional factors (Asia, Europe and North America) or
      • World factors in the case of global funds
    • Information ratios using alphas
slide27

Active Share & Annual Performance:

Benchmark-adjusted returns

Test 3. Returns to Active Management

Benchmark-adjusted Returns

test 3 returns to active management
Test 3. Returns to Active Management
  • Panel regression of future Fund Performance
    • Active Share
    • TNA, age, flows, geographical focus,…
  • In alternative R2 - Amihud and Goyenko (2010)
    • Lower R2: higher deviation from benchmark index
slide29

Active Share predicts higher future performance

1σ increase in Active Share 94 bpper year in return

50 bpper year in alpha

  • Effect pervasive across all benchmark types
    • but strongest for global and regional funds
extensions work in progress
Extensions – Work in Progress

Extend sample period through 2010

Funds may be registered for sale in multiple countries

Rather than assuming domicile as single country of sale

Funds may have multiple share classes

Rather than focusing on primary share class

Calculate Active Sharerelative to

Self-declared benchmark

Benchmark with minimum Active Share

Rather than Lipper “Technical Indicator Benchmark”

conclusions
Conclusions

Little explicit indexing, but lots of closet indexing around the world

Product differentiation (active share) increases with explicit indexing

Fees decrease with explicit indexing, but increase with closet indexing

The most active funds outperformtheir benchmarks, but closet indexing underperform

Explicit indexing indicates more competition and efficiency,but closet indexing indicates the reverse