Jason Greene and Jeffrey Stark, authors of the August 2016 study What’s Trending? The Performance and Motivations for Mutual Fund Startups, examined the motivation behind the launch of a mutual fund as well as its subsequent performance. They employed the Center for Research in Security Prices (CRSP) Survivor-Bias-Free U.S. Mutual Fund Database and used monthly observations of fund returns and total net assets from 1993 to 2014. Their sample included more than 7,000 mutual funds.
Greene and Stark started by parsing mutual fund names to determine which words were trendy, as indicated by market-wide flows to funds that included them. They then quantified the “trendiness” of a mutual fund based on these naming patterns and associated this measure with fund flows over subsequent periods. As you might expect, they found that mutual fund families attempt to attract assets by launching “trendy” funds. They do so to take advantage of investor preferences for a particular style or strategy that’s “hot” or in favor. Said another way, they’re motivated by investor demand rather than their belief in their ability to generate alpha.
Greene and Stark’s Findings
According to Greene and Stark, demand-motivated funds might be launched even when fund sponsors have no expectation of future outperformance. Specifically, they found that new fund launches appear to avoid the least trendy quintiles while the trendier quintiles attract a greater number of fund launches.
Furthermore, Greene and Stark found that the newly launched trendy funds do generate statistically significant additional inflows in their first 12 months. For example, they found that “a fund moving from a percentile rank of 80 to a percentile rank of 100 experiences additional inflows of 9.76%.”
They write: “The results for the top trendiness quintile represent gains in flow that are larger than an equally sized move across any of the lower quintiles, where the maximum benefit is 6.06%.” This finding is consistent with prior research related to the importance of investment names, stock tickers and investor preferences, which has shown that “investors flock to mutual funds whose names reflect current trends.”
Unfortunately, the authors also found that these funds underperform over their first five years compared to non-trendy funds, with the trendiest startup funds underperforming the least trendy startup funds by an average of 1.03 percent per year on a risk-adjusted basis. It shouldn’t be a surprise that Greene and Stark concluded their results “suggest that mutual fund launches appear to be motivated by considerations other than skill.” In other words, acting in their own best interests, mutual fund families rationally exploit investor sentiment-based opportunities through the creation of new, trendy funds.
Finally, Greene and Stark found that the “annual expense ratio for trendy funds is 0.201% higher than for non-trendy funds. These results show support for fund sponsors taking advantage of the higher demand for trendy funds and maximizing revenue through their management.”
Keep these findings in mind the next time you are tempted to invest in the latest, hot trend in mutual funds.
This commentary originally appeared November 11 on MutualFunds.com
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