Investments and Portfolio Performance

The following sections are included:

• PREFACE

• CONTENTS

• ACKNOWLEDGEMENTS

The following sections are included:

• Reasons for the Study

• The Relationship between Ex-dividend Behavior and Stockholder Tax Rates

• Tests of Our Statistic

• Clientele Effect

• Summary

• REFERENCES

Almost all research on the movement of stock prices on ex-dividend days has found that prices decline by less than the dividend. Though this is consistent with tax effects, several papers have argued that this phenomenon could be caused by market microstructure effects. In this paper we make use of a natural experiment that provides support for the tax explanations of ex-dividend behavior. Some closed-end funds have taxable, and some have nontaxable, dividend distributions. Both types are subject to taxes on capital gains. The implication of this for ex-dividend-day price behavior is very different between these two types of funds if taxes matter. This paper demonstrates that the direction of ex-dividend-day price behavior is consistent with a tax explanation and that ex-dividend-day price behavior changes, as theory would suggest, with changes in the tax law.

The following sections are included:

• Corporate Yield Spreads
  • Data
  • Measuring Spreads
  • Empirical Spreads
  • Fit Error

• Estimating the Default Premium

• Estimating The State Tax Premiums

• Risk Premiums For Systematic Risk

• Conclusion

• Appendix A. Determining Yield to Maturity on Zeros (Spot Rates)

• Appendix B. Measuring the Default Premium in a Risk-Neutral World Without State Taxes

• Appendix C. Estimating the Impact of State Taxes

• REFERENCES

An important body of literature in Financial Economics accepts bond ratings as a sufficient metric for determining homogeneous groups of bonds for estimating either risk-neutral probabilities or spot rate curves for valuing corporate bonds. In this paper we examine Moody's and Standard & Poors ratings of corporate bonds and show they are not sufficient metrics for determining spot rate curves and pricing relationships. We investigate several bond characteristics that have been hypothesized as affecting bond prices and show that from among this set of measures default risk, liquidity, tax liability, recovery rate and bond age leads to better estimates of spot curves and for pricing bonds. This has implications for what factors affect corporate bond prices as well as valuing individual bonds.

We investigate the informational efficiency of mutual fund performance for the period 1965–84. Results are shown to be sensitive to the measurement of performance chosen. We find that returns on S&P stocks, returns on non-S&P stocks, and returns on bonds are significant factors in performance assessment. Once we correct for the impact of non-S&P assets on mutual fund returns, we find that mutual funds do not earn returns that justify their information acquisition costs. This is consistent with results for prior periods.

This paper examines problems in the CRSP Survivor Bias Free U.S. Mutual Fund Database (CRSP, 1998) and compares returns contained in it to those in Morningstar. The CRSP database has an omission bias that has the same effects as survivorship bias. Although all mutual funds are listed in CRSP, return data is missing for many and the characteristics of these funds differ from the populations. The CRSP return data is biased upward and merger months are inaccurately recorded about half the time. Differences in returns in Morningstar and CRSP are a problem for older data and small funds.

Mutual funds represent one of the fastest growing type of financial intermediary in the American economy. The question remains as to why mutual funds and in particular actively managed mutual funds have grown so fast, when their performance on average has been inferior to that of index funds. One possible explanation of why investors buy actively managed open end funds lies in the fact that they are bought and sold at net asset value, and thus management ability may not be priced. If management ability exists and it is not included in the price of open end funds, then performance should be predictable. If performance is predictable and at least some investors are aware of this, then cash flows into and out of funds should be predictable by the very same metrics that predict performance. Finally, if predictors exist and at least some investors act on these predictors in investing in mutual funds, the return on new cash flows should be better than the average return for all investors in these funds. This article presents empirical evidence on all of these issues and shows that investors in actively managed mutual funds may have been more rational than we have assumed.

S&P 500 index funds represent one of the simplest vehicles for examining rational behavior. They hold virtually the same securities, yet their returns differ by more than 2 percent per year. Although the relative returns of alternative S&P 500 funds are easily predictable, the relationship between cash flows and performance is weaker than rational behavior would lead us to expect. We show that selecting funds based on low expenses or high past returns outperforms the portfolio of index funds selected by investors. Our results exemplify the fact that, in a market where arbitrage is not possible, dominated products can prosper.

Many investors confine their mutual fund holdings to a single fund family either for simplicity or through restrictions placed by their retirement savings plan. We find evidence that mutual fund returns are more closely correlated within than between fund families. As a result, restricting investment to one fund family leads to a greater total portfolio risk than diversifying across fund families. We examine the sources of this increased correlation and find that it is due primarily to common stock holdings, but is also more generally related to families having similar exposures to economic sectors or industries. Fund families also show a propensity to focus on high or low risk strategies, which leads to a greater dispersion of risk across restricted investors. An investor considering adding an additional fund, either in the same family or outside the family, would need to believe the inside fund offered an extra 50 to 70 basis points to have the same Sharpe ratio.

A number of articles in financial economics have used quarterly or semi-annual mutual fund holdings data to test hypotheses about investment manager behavior. This article reexamines four well-known hypotheses in finance to determine whether the results of prior tests of these hypotheses remain valid when higher frequency (monthly) holdings data are employed. The areas examined are: momentum trading, tax-motivated trading, window dressing, and tournament behavior We find that the use of monthly holdings data rather than quarterly holdings data or, in the case of tournament behavior. holdings data rather than monthly return data, change, and in some cases reverse, previous results. This occurs because monthly holdings data capture a large number of trades missed by quarterly data (18.5% of the trades) and permit a more precise estimation of the timing of trades.

This paper examines the effect of incentive fees on the behavior of mutual fund managers. Funds with incentive fees exhibit positive stock selection ability, but a beta less than one results in funds not earning positive fees. From an investor's perspective, positive alphas plus lower expense ratios make incentive-fee funds attractive. However, incentive-fee funds take on more risk than non-incentive-fee funds, and they increase risk after a period of poor performance. Incentive fees are useful marketing tools, since more new cash flows go into incentive-fee funds than into non-incentive-fee funds, ceteris paribus.

The following sections are included:

• Introduction

• Performance of Spiders
  • Overall Return on Spiders
  • Deviations of Price from NAV
  • Comparison with Alternative Vehicles

• Creation/Deletion

• Determinants of Volume

• Conclusion

• References

The following sections are included:

• An Overview

• The Data
  • Price Data
  • Survey and Announcement Data

• Getting Expected Return

• Tests in the Bond Area
  • A Constant Risk Premium
  • Forward Rates and Risk Premiums
  • Factor Analysis
  • Changing Risk Premiums

• Asset Pricing Tests in the Common Stock Area
  • Information Surprises and Tests of a Particular Asset Pricing Model
  • Number of Priced Factors
  • Implications

• Summary

• REFERENCES

The following sections are included:

• Sample

• Analysis
  • THE BASE MODEL
  • A FIFTH INDEX
  • ESTIMATING THE EFFECT OF COMMON HOLDINGS
  • IS IT COMMON HOLDINGS OR A SYSTEMATIC FACTOR?
  • IS THE ADDITION OF MGO ENOUGH?

• Test on Passive Portfolios

• Conclusion

• Acknowledgements

• References

The choices made by 401(k) participants are the product of two different decisions: what is offered and what is chosen. While there have been a number of studies of the decisions made by participants in 401(k) plans, there have been no studies of the adequacy of the full set of choices offered to 401(k) participants. This paper analyzes the adequacy and characteristics of the choices offered to 401(k)-plan participants for over 400 plans. We find that only 53% of the plans offer an adequate set of options and that over a 20-year period offering inadequate options makes a difference in terminal wealth of over 53%. We find that funds included in the plans are riskier, but have a slightly higher return, than the general population of funds in the same categories. However, we find that the return difference is roughly equal to the difference in expenses between funds selected by plans and randomly selected funds. We study the characteristics of plans that are associated with adequate investment choices, including an analysis of the use of company stock, plan size, and the use of sophisticated strategies.

This is the first study to examine both how well plan administrators select funds for 401(k) plans and how participants react to plan administrator decisions. We find that, on average, administrators select funds that outperform randomly selected funds of the same type although they do not outperform index funds of the same type. When administrators change offerings, they choose funds that did well in the past, but, after the change, added funds do no better than dropped funds. Plan participants in aggregate change their allocation decisions in a way that accentuates the changes in allocation caused by returns. The change in allocation due to the investment of new money and interfund transfers is about the same size, and in the same direction. as the change due to returns. Participant allocations in aggregate do no better than naïve allocation rules, such as equal investment in each offering.

The following sections are included:

• THE SINGLE INDEX MODEL AND THE CONSTRUCTION OF OPTIMAL PORTFOLIOS
  • Optimum Portfolios with Short Selling
  • Optimal Portfolios When Short Sales Are Not Allowed

• CONSTANT CORRELATION COEFFICIENTS AND THE CONSTRUCTION OF OPTIMAL PORTFOLIOS
  • Optimal Policies When Short Sales Are Allowed
  • Optimal Policies When Short Sales Are Not Allowed

• CONCLUSION

• APPENDIX A

• APPENDIX B

• APPENDIX C

• REFERENCES

Many financial institutions employ outside portfolio managers to manage part or all of their investable assets. It is well recognized that outside portfolio managers are unwilling to share security information with each other or with the centralized decision maker and this in general will lead to sub-optimal portfolios. In this paper, we derive an implementable set of rules under which a central decision maker can make optimal decisions without requiring decentralized decision makers to reveal estimates of security returns. Furthermore, we derive conditions under which these rules hold and when they do not hold.

The popular finance literature describes the asset allocation decision as one of the most important factors in determining investment performance. This article reviews the implications of modern portfolio theory for the asset allocation decision and then examines the recommendations of some leading financial experts to see if they are consistent with theory.