Results - Furman University

  • Doc File 100.00KByte



PERFORMANCE OF MUTUAL FUNDS OPERATED BY FINANCIAL SERVICES FIRMS

Vance P. Lesseig, Texas State University – San Marcos, San Marcos, Texas, USA

D. Michael Long, University of Tennessee-Chattanooga, Chattanooga, Tennessee, USA

Thomas I. Smythe, Furman University, Greenville, South Carolina, USA

ABSTRACT

This paper assesses the performance of mutual funds owned and operated by banks, securities firms, and insurance companies. The financial skills possessed by these types of firms suggest they would have advantages in terms of expertise and performance in fund management over other fund sponsors. In general, we find that financial firms have no significant performance advantage in fund management, a finding consistent with efficient markets. However, contrary to prior studies, we find that bank-owned funds as a group do not underperform. Finally, we provide evidence that foreign-owned mutual funds underperform, even after controlling for higher expenses.

Keywords: Mutual funds, financial institutions, returns

1. INTRODUCTION

The number of mutual funds continues to grow and has now become the primary vehicle that small investors use to participate in the capital markets. This growth is expected to continue especially with the recent push for legislation to help increase investor participation in company sponsored defined contribution plans, as well as the possible reform of the Social Security system. As the popularity of funds grows, a body of research is addressing various aspects of mutual fund performance and costs. This paper seeks to add to this literature by investigating whether funds operated by financial services firms (i.e., banks, insurance companies, and securities firms) compare favorably to other funds in terms of performance. Although, previous literature has examined performance of a limited subset of bank-owned mutual funds, we are not aware of any studies that examine the performance of funds owned by the broader class of financial services firms. In addition, we further segregate our sample by analyzing returns for each type of fund under management (equity, fixed income, and international funds) for each ownership structure (banks, insurance companies, and securities firms).

To the casual observer it may seem that financial services firms are well qualified to operate funds efficiently and successfully due to economies of scale in fund administration. However, our findings suggest that investors are not necessarily the beneficiaries of this efficiency. Although studies show that financial services firms may possess cost advantages over other fund operators (see Lesseig, Long, and Smythe, 2002 and 2005), lower costs do not always translate into higher returns to the investor. On average, these firms display no significant performance advantages or disadvantages, although when observations are separated by fund objective the story changes. Bank-owned funds display significantly lower returns than peer funds in the fixed-income category. While this may seem counter-intuitive given their experience managing their own asset portfolios, the finding is consistent with prior studies (Bogle and Twardowski, 1980 and Bauman and Miller, 1995), although it contradicts some of the results of Frye (Frye, 2001). However, banks seem to outperform their peers in international equity funds, but show no significant abnormal performance in domestic equity funds.

Funds owned by securities firms fail to outperform in any category, even though they typically charge higher management fees than banks and insurance companies. However, investors in these funds do not seem to suffer any abnormal losses either. Insurance company-owned funds show higher returns in the aggregate, but have no significant abnormal returns in any particular fund category. In addition to our findings regarding financial services ownership, we provide some disheartening evidence for investors in mutual funds operated by foreign-owned firms. Specifically, we show that these funds have significantly lower return performance in the equity and international markets.

Background literature and the motivation for this study are discussed in the next section. In section three, data collection and testing methods are introduced. Results are presented in section four, while concluding remarks are provided in section five.

2. Background and Motivation

A great deal of prior research has examined the relation between mutual fund expenses and returns. In his book, Bogle spends the better part of a chapter discussing and demonstrating how fund costs impact returns (Bogle, 1999). Studies by Carhart (Carhart, 1997) and Malkiel (Malkiel, 1995) show that funds with lower expenses tend to have higher returns. Finance literature documents several factors related to expense ratios including turnover, international versus domestic orientation, fund size, and fund structure. More recently, Lesseig, Long, and Smythe (Lesseig et al, 2005) show that ownership structure plays an important determinant of mutual fund expenses. They find that banks, securities firms, and insurance companies generate savings in the administration of mutual funds. However, only banks and insurance companies are passing some of these savings on to investors in the form of lower expense ratios, while security companies’ administrative savings are offset by higher management fees. This leads to the question of whether the administrative advantage possessed by banks and insurance companies in managing mutual funds can translate into higher returns.

Also, Malhotra and Mcleod (Malhotra and Mcleod, 1997) point out the importance of comparing funds by expense ratios due to the difficulty in establishing a clear link between volatile returns and management skill. They find that funds with high expense ratios take on more risk in an effort to earn higher returns to offset the higher expenses. As previously stated, Lesseig, Long, and Smythe (Lesseig et al, 2005) show that funds owned by financial services firms have lower expense ratios than other funds. This raises the question of whether financial services funds can offer the same net return as other funds without necessarily taking on additional risk.

Other papers argue that fund managers appear to increase the risk of their funds in an effort to generate higher returns to overcome higher expense ratios (see Frye, 2001). Additionally, Frye (Frye, 2001) challenges the argument that bank-affiliated funds underperform due to their conservative nature. By examining bond funds, she demonstrates that the performance of a bank-owned fund depends on the specific type of bond fund under management. Frye finds little evidence of underperformance in most bond categories. She also shows that bank funds tend to be less risky than non-bank funds, when risk is measured by standard deviation of returns.

Other literature has examined the impact of bank-owned mutual funds on both the banks and fund investors. Traditionally, most researchers hold that bank-owned funds underperform relative to other funds. For example, Bogle and Twardowski (Bogle and Twardowski, 1980) and Bauman and Miller (Bauman and Miller, 1995) find that bank-owned portfolios tend to underperform non-bank-owned portfolios. However, neither study examines how bank-sponsored mutual funds compete with non-bank funds based on objective class. That is, both papers compare bank portfolios with different fiduciary standards than those of their non-bank samples. However, two recent papers do address the performance of certain categories of bank-owned mutual funds having the same regulatory structure as other funds in specific investment classes. Koppenhaver (Koppenhaver, 2000) examines money market funds and finds that banks outperform funds affiliated with other financial institutions. Koppenhaver argues the abnormal performance may be due to bank expertise in money market securities, but implies such an advantage may not exist for equity funds. Our investigation of equity, fixed income, and international funds shows support for his implication.

3. DATA AND Methodology

3.1 Data

One concern in this paper relates to our sample, specifically the fact that only one year of complete data from 1997 is available. We address this concern in two ways.

First, similar to Lesseig, Long, and Smythe (Lesseig et al, 2002), our data comes from a unique combination of data sources, which makes multi-year analysis untenable. The sample includes all fund classes in existence from Lipper’s General Equity, World Equity, and Fixed-Income categories as of year-end 1997. The Lipper database is unique in that it includes information on all of our control variables except those related to corporate ownership of the fund. Our return data is collected from Morningstar and is net of fund expenses. Unfortunately, ultimate fund ownership is not available in electronic form with other fund data. Neither Morningstar nor Lipper identifies ultimate fund owners.

While the names of many fund families indicate the identity of a corporate owner (e.g., Fidelity Puritan), many are not as easily discernable (e.g., Evergreen funds are owned by First Union/Wachovia). As such, sponsorship information must be hand collected, which is an extremely time intensive process. Thus, our data combination of control variables, returns, and break-down of fund owners is simply not available on a multi-year basis because of changes in fund ownership from year-to-year. However, we believe that the exclusivity of this data set will provide investors new insight into the performance of specific fund sponsorship type, as well as their performance based on fund objective.

Secondly, our sample is not small; it consists of 1883 observations. Thus, based on the size of the data set and that there is nothing extraordinary about 1997, there is no reason to believe that our results are biased one way or the other. Therefore, we believe it is reasonable to draw some general opinions from our data on the performance of mutual funds operated by financial services firms. In addition, we believe that this study’s contribution is important, because as new technology makes it easier to collect detailed data such as ours, these results will provide a basis for future work in this area.

3.2 Methodology

A great deal of research has examined mutual fund performance. However, to date no research has investigated the returns of mutual funds specifically operated by banks, securities firms and insurance companies. In our examination, we define fund return as an “excess return”, which is not risk-adjusted beyond the investment objective classifications. We contend that most individual investors do not explicitly consider risk-adjusted measures such as Sharpe Ratios or Jensen Alphas in their decisions. Bogle (Bogle, 1994) argues that investors identify risk with a given investment objective and implicitly assume funds in the same objective have similar risk. Thus, to the extent fund managers are aware of how investors use return data to make fund choices, they are more likely to focus on raw performance and/or performance adjusted by investment objective in making their investment decisions. This is further supported by the tournament literature as developed in Brown, Harlow, and Starks (Brown, et al, 1996) and Chevalier and Ellison (Chevalier and Ellison, 1997). Additionally, DelGuercio and Tkac (DelGuercio and Tkac, 2002) provide evidence that retail mutual fund investors focus on raw returns and not risk-adjusted measures as do pension fund fiduciaries.

Therefore, our adjusted return (ADJRET) measure is computed from fund return net of expenses for 1997 (as reported by Morningstar) minus the median return of the fund’s objective class (growth, income, etc.) to which it belongs. This methodology is comparable to industry-adjusted returns in the corporate finance literature. The cross-sectional regression of ADJRET is as follows:

ADJRET = α + β1BANK + β2SECURITIES + β3INSURANCE + β4INTL + β5INSTL + β6TURN +

β7NET96 + β8MS + β9LNAGE + β10FELI + β11LNASSETS + β12LNSPASSET +

β13CDSCI + β14LLI + β15EXPENSE + β16MKTFEE + ε (1)

where, BANK, SECURITIES, and INSURANCE are dummy variables equal to one if a bank, securities, or insurance firm operates the fund or class, respectively, and zero otherwise. The coefficient estimates for BANK, SECURITIES, and INSURANCE indicate the relative performance of each type of fund owner. Based on our prior discussion, the sign for the BANK coefficient is indeterminate. If lower expenses dominate the expected risk-averse investment policy demonstrated by Frye (Frye, 2001), then bank-owned funds will have higher net returns, and the estimate of (1 will be positive. But, if banks do take on less risk and the subsequent lower gross returns dominate the expense effect, then the coefficient estimate for BANK will be negative. An insignificant coefficient estimate will indicate that any savings from lower expenses are exactly offset by lower performance by the fund.

TABLE 1. VARIABLE DEFINITIONS FOR REGRESSION ANALYSIS

ADJRET: The fund's return for 1997 net of fund expenses as reported by Morningstar, minus the median return for the investment objective (i.e., growth, income, etc.) to which the fund belongs.

BANK: An indicator variable equal to 1 if the fund is operated by a bank, and 0 otherwise.

SECURITIES: An indicator variable equal to 1 if the fund is operated by a security firm, and 0 otherwise.

INSURANCE: An indicator variable equal to 1 if the fund is operated by an insurance company, and 0 otherwise.

MS: An indicator variable equal to 1 if the observation is a class of a multiple share class fund, and 0 otherwise.

LNASSETS: The natural logarithm of fund/class assets under management of a particular fund class within a fund family (e.g., Fidelity Puritan fund), as of year-end 1997. It is used to capture scale economies within that fund.

LNSPASSET: The natural logarithm of all assets under management for a sponsor, where a sponsor is the ultimate owner of the fund (e.g., Fidelity), as of year-end 1997. This variable captures shared costs across multiple funds, and economies of scale and scope at the corporate ownership level.

LNAGE: The natural logarithm of a fund’s age in years since inception.

TURN: Percentage turnover in a fund’s/class’ assets in 1997.

INTL: An indicator variable equal to 1 if the sponsor of the fund is owned by an international company, and 0 otherwise.

INSTL: An indicator variable equal to 1 if the observation is for institutional or high net worth investors, and 0 and zero if retail investors.

FELI: An indicator variable equal to 1 if the observation has a front-end load, and 0 otherwise.

CDSCI: An indicator variable equal to 1 if the observation has a contingent deferred sales charge, and 0 otherwise.

LLI: An indicator variable equal to 1 if the observation has a level load, and 0 otherwise.

EXPENSE: A fund’s expense ratio is expressed as a percentage of assets net of its 12b-1 fee, and consists of an administrative fee and a management fee.

MKTFEE: An indicator variable equal to 1 if the observation has a 12b-1 fee, and 0 otherwise.

NET96: The 1996 fund/class return, net of the median return for the observation’s objective. This is a measure of relative performance of the fund class, which is equal to the return for the fund class minus the median return for the investment objective category to which the fund belongs for the year 1996.

Additionally, there are no clear predictions for the SECURITIES and INSURANCE coefficients. Intuitively, we expect securities firms to have the greatest degree of expertise in security selection and portfolio management, so we may see them cross-sectionally outperform funds operated by other types of firms.

Similar to banks, we anticipate lower expenses for funds owned by both securities firms and insurance companies to give the funds an advantage in terms of net returns. Thus, if these funds underperform, it would be in excess of any savings they generate from lower expenses. Positive coefficient estimates for either variable will indicate that the fund owner generates benefits for the investor either through savings from lower expenses, or through superior investment performance within that investment objective class.

The remaining independent variables in equation (1) have appeared in previous literature and are used here as control variables. We provide a detail summary of all variables in Table 1.

4. RESULTS

As previously defined, the ADJRET measure is computed as the net fund return for 1997 minus the median return of funds in the objective class (growth, income, etc.) to which it belongs. We examine the returns of these funds to determine if financial services firms display any additional expertise in fund management relative to other firm types managing funds. Also, for reasons of brevity, only estimates for the primary variables discussed in the paper (i.e., BANK, SECURITIES, INSURANCE, INTL, INSTL, TURN, NET96, MS, and EXPENSE) are included in Table 2. Although estimates for the remaining control variables are not presented in tabular form, they are available from the authors upon request

In Table 2, Panel A illustrates the overall results of the regression model in equation (1). For BANK and SECURITIES the coefficient estimates are insignificant. Thus, it appears that neither of these ownership classes performs any better or worse than any other fund owners. Only insurance company-owned firms show significant excess returns. The coefficient estimate for INSURANCE is positive and significant at the five percent level, indicating that funds owned by insurance companies actually outperform those of other funds after controlling for a wide range of other factors.

The insignificance of the coefficient estimate for BANK may be surprising given some of the previous research that has indicated poor performance by banks. It is important to remember, that these are returns net of expenses, and we control for expenses in the regressions. Thus, it is possible that the gross returns may be lower, but are offset by the lower expenses charged by bank-owned funds. (see Lesseig et al, 2005)

Among the control variables, we find that the coefficient estimates for INTL and TURN are both negative and significant, indicating that funds with foreign ownership or high turnover have lower returns than peer funds. The findings for high turnover and foreign-owned fund returns are interesting, especially since both characteristics have been shown to lead to higher expenses in prior studies. Apparently high activity in a fund, which clearly increases costs, does not result in increased returns through timing—a finding consistent with efficient financial markets. For foreign-owned funds, the results are especially enlightening. As discussed in previous sections, foreign-owned funds do not necessarily incur higher administrative costs, as their administrative fees are comparable to domestically-owned funds. However, these funds do have higher management fees, although apparently, they are not generating the returns to justify the higher fees. Clearly this finding should be of interest to any mutual fund investor.

In Table 2, Panel B, we segregate the sample by fund objective. Specifically, ADJRET for equity, fixed income, and international funds is analyzed separately using equation (1). The greater detail provided in Panel B shows banks become the most interesting owner type. While bank-owned funds show no abnormal performance in the aggregate, closer inspection reveals the reasons. Bank-owned fixed income funds significantly underperform other fixed income funds, but significantly outperform international funds operated by other types of firms. A priori, we would expect banks to perform better in the fixed income category given their perceived skill as credit analysts and as managers of their own portfolios, which consist largely of fixed-income securities. Consequently, we would expect equity funds to be banks poorest performing class. While the findings for fixed income appear at odds with Frye (2001), our analysis is slightly different. We do not break the category down to the same extent, and we use a different model to determine and analyze abnormal returns. However, Frye (2001) does find underperformance by bank-owned funds in some bond categories. Frye also finds that bank-owned funds hold significantly less risky portfolios than do other owners. Our results indicate that the risk-averse nature of bank investments likely depresses the returns in this class more than the savings generated in fund administration. In addition, bank ownership of the fund is not the only thing to avoid when selecting a fixed-income fund. An MS structure and a high base expense ratio all contribute to lower net returns for fixed income funds.

In contrast to fixed income funds, we find that bank-owned funds using the MS structure to manage international funds are the best performers. The coefficient estimates for banks and MS funds are positive, significant, and large in magnitude. The superior performance of banks in the management of international funds may be the result of their experience with international lending. Most of the banks that own mutual funds tend to be the larger banks that have an international presence. Apparently these banks are able to turn their lending expertise in overseas markets into strong returns for their international mutual funds. We do find that insurance companies managing international funds outperform peer funds, although the significance level of ten percent for INSURANCE is not as strong as that for BANK.

TABLE 2

PANEL A shows results from estimating equation (1) for the dependent variable ADJRET.

PANEL B shows results from estimating equation (1) after segmenting the dependent variable by investment class (i.e., Equity, Fixed Income, and International funds). (P-values in parentheses.)

| | | | |

| |PANEL A | |PANEL B |

|Independent | | |ADJRET |ADJRET |ADJRET |

|Variables |ADJRET | |Equity |Fixed Income |International |

| |0.223 | |-0.369 |-0.479 |2.039 |

|BANK |(0.506) | |(0.500) |(0.001)*** |(0.027)** |

| |-0.293 | |-0.590 |-0.242 |-0.593 |

|SECURITIES |(0.465) | |(0.407) |(0.107) |(0.525) |

| |.0661 | |0.103 |0.152 |1.537 |

|INSURANCE |(0.040)** | |(0.838) |(0.275) |(0.080)* |

| |-1.915 | |-1.453 |-0.010 |-3.949 |

|INTL |(0.000)*** | |(0.020)** |(0.581) |(0.000)*** |

| |0.148 | |1.814 |-0.077 |-2.142 |

|INSTL |(0.732) | |(0.010)*** |(0.687) |(0.040)** |

| |-0.005 | |-0.027 |-00001 |0.015 |

|TURN |(0.000)*** | |(0.000)*** |(0.966) |(0.005)*** |

| |0.038 | |0.359 |0.219 |0.185 |

|NET96 |(0.000)*** | |(0.000)*** |(0.039)** |(0.006)*** |

| |0.326 | |-0.387 |-0.247 |2.377 |

|MS |(0.340) | |(0.468) |(0.074)* |(0.008)*** |

| |-1.722 | |-1.603 |-1.245 |-0.851 |

|EXPENSE |(0.135) | |(0.483) |(0.001)*** |(0.354) |

| |0.837 | |5.195 |0.256 |-14.527 |

|Constant |0.764) | |(0.415) |(0.822) |(0.005)*** |

***Significant at one percent level; **Significant at five percent level; *Significant at ten percent level.

Once again we find that foreign-owned funds demonstrate poor performance. The coefficient estimate for INTL is negative and significant at the five percent level for equity funds and at the one percent level for international funds. Clearly, underperformance of foreign-owned funds in managing international funds is worthy of note. The magnitude of the negative coefficient for international funds is very large, and could well be driving the overall underperformance shown in Table 2, Panel A. Given these results, there seems to be little incentive for investors to choose foreign-owned funds—especially for international funds where investors might have expected these sponsors to have an advantage.

The one consistent finding across fund types is the effect of past performance. In each column of Table 2 the coefficient estimates for NET96 are positive and significant at the five percent level or better. Although this is only a one-year effect in our sample, it is worthy of future investigation.

5. CONCLUSIONS

Prior studies have shown that financial services firms are well qualified to operate funds more efficiently due to economies of scale and scope in fund administration. However, our findings suggest that investors are not benefiting from this efficiency in terms of higher returns. In general, lower fees generated by savings in administrative expenses are not enough to produce positive excess returns for investors in bank or securities-owned funds. On average, these firms display no significant advantage or disadvantage in performance. In fact, we find only insurance company-owned funds generate positive excess aggregate returns.

However, when we examine returns by objective class the story changes. We find that banks are surprisingly poor performers in the fixed income category. Although we believe that banks’ natural aversion to risk may contribute to their poor performance in fixed income funds, we leave this work to future analysis. We do offer that the vaunted underperformance of bank-owned funds is not present in domestic equity funds, and that banks actually display some expertise with regard to international funds, where they show strong positive returns. We also find that insurance-owned funds show positive performance in managing international funds.

However, this expertise in international funds is not shared by foreign-owned managed funds. Although from prior research, we know foreign-owned funds charge higher management fees than other funds, we show they are not generating the returns necessary to justify the higher fees. As stated previously, we think most mutual fund investor would find this information valuable.

In addition, investors in securities firm-owned funds do not appear to suffer significantly lower returns, even though securities firms tend to have higher expense ratios due to higher management fees (Lesseig, et al, 2005). This is true in the aggregate, as well as by objective class.

We believe this research is a good beginning in providing investors insight into the performance of specific fund sponsor type (i.e., banks, insurance companies, and security firms), as well as performance based on a fund’s objective class (i.e., equity, fixed income, and international funds). We offer these findings as an initial investigation that should spur future work on the subject of fund ownership and its impact on investors.

References

Bauman, W.S. and R.E. Miller, “Portfolio Performance Rankings in Stock Market Cycles,” Financial Analysts Journal, 51, 1995, 79-87.

Bogle, J. and J. Twardowski, “Institutional Investment Performance: Banks, Investment Counselors, Insurance Companies, and Mutual Funds,” Financial Analysts Journal, 36, 1980, 33-41.

Bogle, J., Bogle on Mutual Funds, Dell Trade Paperback, 1994.

Bogle, J., Common Sense on Mutual Funds, John Wiley and Sons, Inc., 1999.

Brown, K., W.V. Harlow, and L. Starks, “Of Tournaments and Temptations: An Analysis of Managerial Incentives in the Mutual Fund Industry,” Journal of Finance, 51, 1996, 85-110.

Carhart, M. M., “On Persistence in Mutual Fund Performance,” Journal of Finance, 52, 1997, 56-82.

Chevalier, J. and G. Ellison, “Risk Taking by Mutual Funds as a Response to Incentives,” Journal of Political Economy, 105, 1997, 1167-1200.

DelGuercio, D. and P. A. Tkac, “The Determinants of the Flow of Funds of Managed Portfolios: Mutual Funds vs. Pension Funds,” Journal of Financial and Quantitative Analysis, 37, 2002, 523-557.

Frye, M. B., “The Performance of Bank Managed Mutual Funds,” Journal of Financial Research, 24, 2001, 419-442.

Koppenhaver, G. D., “Circle Unbroken: Bank-affiliated Money Market Mutual Funds,” Iowa State Working Paper, 2000.

Lesseig, Vance P., D. Michael Long, and Thomas I. Smythe, “Gains to Mutual Fund Sponsors Offering Multiple Share Class Funds,” Journal of Financial Research, 25, 2002, 81-98.

Lesseig, Vance P., D. Michael Long, and Thomas I. Smythe, “The Impact of Fund Sponsorship on Expenses in the Institutional and Retail Fund Markets,” University of Tennessee working paper, 2005.

Malkiel, B. G., “Returns from Investing in Equity Mutual Funds 1971 to 1991,” Journal of Finance, 50, 1995, 549-572.

Malhotra, D. K. and R. W. McLeod, “An Empirical Analysis of Mutual Fund Expenses,” Journal of Financial Research, 20, 1997 175-190.

Author Profiles:

Dr. Vance P. Lesseig earned his Ph.D. at the University of Oklahoma in 1999. He is currently an assistant professor of finance at Texas State University – San Marcos.

Dr. D. Michael Long earned his Ph.D. at the University of Kentucky in 1992. He is currently an associate professor of finance at the University of Tennessee-Chattanooga, and holds the UBS Professorship in Portfolio Management.

Dr. Thomas I. Smythe earned his Ph.D. at the University of South Carolina in 1999. He is currently an assistant professor of finance at Furman University in Greenville, South Carolina, and holds the Robert E. Hughes Professorship in Finance.

................
................

Online Preview   Download