EXECUTIVE SUMMARY

ON PERSISTENCE OF MUTUAL FUND

PERFORMANCE

Kevin Haughey
Caleb Migosi
I. Introduction
Carhart suggests that it is the common factors in stock returns and the persistent
differences in mutual fund expenses and transaction costs which account for almost the
entirety of the predictability in mutual fund returns. He also believes that persistence in
mutual fund performance reflects much less an ability to superiorly pick stocks (or follow
momentum strategies) than a chance occurrence that the manager picked a higher
proportion of last year’s winning stocks. For this reason, “hot hands” infrequently repeat
their performance.

Numerous aspects of mutual fund performance are tackled in this study. The key features
of performance relate to strategies in relation to expense ratios, transaction costs and
turnover. To begin with, he demonstrates the negative impact of transaction costs on fund
performance irrespective of strategy. Additionally, he estimates that trading reduces
performance by about 1% of the trade’s market value. He also finds that load fees1 are
negatively related to fund performance.

This article attempts to build on previous work by controlling for 2survivor bias and by
documenting common-factor and cost-based explanations for mutual fund persistence.
However, the larger question of the joint-hypothesis3 problem comes into play. If the
alphas4 are to be considered, then there is an implicit question of market efficiency. The
assumption being made here is that the four-factor model correctly accounts for a large part
of the variation in returns. This would have to be tested by splitting our dataset into a
training and a test set, to see the performance of the model in predicting out of sample
returns.

II. Methodology
a) Data Collection
Carhart looks at diversified equity funds from ’62 Jan – ’93 Dec (around 32 years). He
ensures that the data is free of survivor-bias by including all known equity funds during this
period. The sample has approximately 2000 diversified equity funds but omits: sector
funds, international funds and balanced funds. The remaining funds are roughly equally
divided amongst the following categories: aggressive growth, long-term growth and growth-
and-income. In an average year, the sample includes about 500 funds with average Total
Net Assets of around $200m and average expenses of about 1% per annum.

In an average year, funds trade around 80% of the value of their assets. Over the full
sample, around 65% of funds charge load fess, which average at 7%. By the end of data
collection, around 1/3 of the total funds in the sample had ceased operations. This

1 Load fees are sales charge commissions charged to clients whenever they redeem their shares.
2 Survivor-bias appears when we make the logical error of concentrating on mutual funds which are still
existent while excluding those that no longer exist
3 The joint hypothesis defines the situation whereby it is impossible to attribute anomalous performance of

assets to market inefficiency seeing that no model is perfect. The error could therefore either be caused by the
model itself or market inefficiency. Being able to differentiate the to is next to impossible.
4 The alpha of a portfolio is the excess return relative to the expected portfolio return calculated by the model
continues to show the impact of survivorship bias in any analysis of mutual fund
performance.

b) Models of Performance Measurement

Carhart employs two different model of performance measurement:
1. CAPM
2. His own 4-factor model: Carhart (1995)

1) CAPM
The CAPM has as its primary hypothesis that the expected returns of a portfolio of assets
can be described by a single factor that is the measure of the variation of the portfolio’s
return with respect to the market return. The CAPM formula is widely known:

Where rit is the return on a portfolio in excess of the one-month T-bill return, VWRF is the
excess return on the value-weighted portfolio of all index stocks.

2) Carhart 4 Factor Model

Carhart constructs his model beginning with Fama & French’s 3-factor adding an additional
factor capturing the one-year momentum anomaly. Similar to the CAPM, a number of
factors (including the Market return factor RMRF in this case) are used to explain the
performance of the portfolio. These are:

HML: A measure of excess returns of high book to market vs low book to market stocks
SMB: A measure of the excess returns of small cap stocks to large cap stocks
Momentum: Return measure of a portfolio long previous 12 month winning stocks and
short 12 month losing stocks

3-factor

4-factor

At the start of every year, Carhart forms 10 equal-weighted portfolios of mutual funds, using
reported returns. He holds the portfolios for one year and then re-forms them – yielding a
time series of monthly returns on each decile from ’63 – ’93. Funds which disappear during
the year are included in the equal-weighted average until they disappear and then
readjustment occurs.

As observed in Table III, Portfolio 1A outperforms 10C by about 1% per month. Also, cross-
sectional variation in return is a lot larger among the previous year’s worst performers than
the previous year’s best performing funds. Considering that many of these funds have the
same Betas, but vastly different returns, it is clear that the CAPM is not a good tool for use
in performance measurement.

The 4-factor model, however, explains most of the spread and pattern in these portfolios,
with sensitivities to the momentum (PR1YR) and size (SMB) factors accounting for the
majority of the explanation. The top decile seems to hold more small stocks than the
bottom decile, thence the higher performance and strong correlation to the SMB and
momentum factors. Except for the relative underperformance by last year’s worst
performing, the 4-factor accounts for almost all of the cross-sectional variation in expected
return on portfolios of mutual funds sorted on lagged one-year return.

Table III

c) Expense Ratios, Turnover and Maximum Load vs Performance

To test whether expenses and other variables have a negative impact on the performance of
mutual funds, Carhart regresses each of these characteristics against the return of the
mutual funds. The results are summarized on Table V, indicating statistical significance for
all characteristics (with the exception of TNA) and an associated negative impact on each of
them. We infer, for example, from the table that a 1% increase in expense ratio on average
leads to a 1.54% decline in performance of the fund. As for the turnover, a 0.95% drop in
returns is expected for every round trip of turnover.
Table V

d) Transaction Costs vs Performance

Carhart checks whether estimates of costs per transaction explain any of the remaining
abnormal performance which is not fully accounted for by the 4-fctor model, expense ratios
and turnover. To do this, Carhart creates a liquidity mimicking portfolio VLMH constructed
by shorting liquid stocks while being long illiquid stocks under the hypothesis that the
illiquid stocks should have a wider bid-ask spread. This historical spread is orthogonalized to
the 4-factor model to produce results indicative of a strong relationship between
performance and transaction costs.

III) Results and Interpretation

a) Short term performance on Past-Winner Mutual Funds
Carhart concludes that one-year performance persistence is mostly eliminated after a year.
Abnormal performance and mean returns across deciles don’t differ significantly after one
year – except perhaps for the persistent underperformance exhibited by the worst funds.
We observe this effect in Figure 2.

Figure 2
In addition to this, the returns on the top and bottom decile funds are not strongly related
to the one-year momentum effect in stock returns, outside of the ranking and formation
years. Carhart tests for performance of momentum managers by sorting mutual funds into
portfolios on their 4-factor model PR1YR loadings. He finds that one-year momentum funds
do not earn significantly higher returns than contrarian funds. Momentum funds also have
high turnover and expense ratios – this implies that most of the gains from following the
one-year momentum strategy are consumed by higher expenses / transaction costs.

Carhart’s understanding of these results is that many of these funds do not have explicit
momentum strategies but only happen to be holding the previous year’s winning stocks.
The returns on these are above average during the ensuing year, therefore by simply
holding their winning stocks, they enjoy higher one-year expected returns without
additional transaction costs.

b) Two-to-Five-Year-Return Sorted Portfolios (P74)

If skill exists, then one-year returns are probably a noisy measure. To reduce this noise in
the past performance rankings, Carhart forms portfolios of mutual funds on lagged two-to-
five-year returns. He then repeats previous analysis by examining how much cross-sectional
variation in mean return can be explained by the 4-factor, expense-ratios and transaction
costs.

Figure 3

It appears that using longer intervals of past returns does little in revealing more
information about the expected future mutual fund performance. This is more a critique of
the 4-factor model itself since it manages to explain only half of the spread between the top
and bottom decile in 2-year data and almost none of the 5-year data. An important question
as to the viability of this model in performance measurement should therefore be asked at
this stage. This could call into question a large part of the endeavour of the paper if the
model is efficient only on one-year data.
Considering the 4-factor model has already been “trained”5 in the past and that our current
dataset is the out of sample data, then he should perform a simulation for every year on
every single portfolio and find the distribution of the errors. If there is any bias or the
variance of prediction is too big, then his model is not suitable for performance
measurement. Carhart himself points to Grinblatt & Titman (’92) who in fact find stronger
evidence of performance persistence in mutual funds.6 Grinblatt, Titman & Kent (1997) push
this idea further in identifying that growth strategies do consistently provide positive alphas
for a number of funds but that most of the skill occurs in selection as opposed to timing.

c) Three-Year, 4-Factor, Alpha-Sorted Portfolios (P76)

As noted above, both the CAPM and the 4-factor model seem to be inefficient in
performance measurement over longer periods of time. As seen in the table below, the
ratio of the Excess Returns to the standard deviation does not show a specific trend
implying that the model used cannot be reliably used to predict expected risk adjusted
returns for the portfolios. In essence, for longer term data, the 4-factor model becomes just
as inefficient as the CAPM. Much of the difference between the top and bottom deciles is
actually explained by expense ratios, load and turnover.

Table VI

Conclusion
Carhart’s study demonstrates the non-replicability of performance by mutual funds using
the 4-factor model. He demonstrates the negative impact of expense ratios, load fees and
turnover on performance of mutual funds on a net basis. He also demonstrates that the
short-term persistence of mutual fund performance can largely be explained by the fact that
many of the top mutual funds hold a larger proportion of the previous year’s winning stocks,
a fact that is accounted for by the momentum factor. However, it is clear that the model
cannot be used to analyse long term persistence in mutual fund performance on account of
the 4-factor model being inadequate in accurate performance evaluation.

5 In data analysis, we split the data into the training set where we obtain the model parameters that are
suitable for the analysis at hand and the test set where we provide out of sample data to enable us to test the
performance of our model.
6 They, in fact, find persistence in performance of mutual funds over time, indicating the presence of skill in

some asset managers.

References
• Grinblatt, M., Titman S. (1992)The Persistence of Mutual Fund Performance
Journal of Finance, Wiley Online Library
• Grinblatt, M., Titman S., Kent D. (1997). Measuring Mutual Fund Performance with
Characteristic‐Based Benchmarks, Journal of Finance, Wiley Online Library
• Hendricks D., Patel J., Zeckhauser R., Hot Hands in Mutual Funds: Short-Run
Persistence of Relative Performance, Journal of Finance, Wiley Online Library.