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Weathering the Financial Storm: Is Your Mutual Fund Capable of Providing Good Returns During Tough Times?

Barbara J. Davis Sample Endowed Chair in Business Administration Frost School of Business Centenary College of Louisiana 2911 Centenary Blvd. Shreveport, LA 71104 318-869-5153

Helen B. Sikes Professor of Accounting and Finance Frost School of Business Centenary College of Louisiana 2911 Centenary Blvd. Shreveport, LA 71104 318-869-5182

Abstract The purpose of this paper involves evaluating mutual fund performance in light of the severe financial crisis the world has faced since 2008. Smart Money, The Wall Street Journal Magazine, in its February 2009 issue identifies 100 mutual funds that are supposed to be great funds for tough times. The research project focuses on evaluating performance of these mutual funds to determine what commonalities they possess to help investors weather the financial storm we are currently dealing with in the investment arena. This research topic fits in the finance category of agency theory.

Introduction In finance, agency theory deals with the problems and conflicts arising when a principal agent relationship exists. The agent is hired by the principal and acts on the principals behalf. But how does the principal ensure that the agent always considers the interests of the principal first? What if the agent is working for his or her self-interests and not making the best decision for the principal? Essentially agency theory involves the costs of resolving conflicts between the principals and agents and aligning interests of the two groups. The mutual fund managers act as agents for the principals, the investors in the mutual fund managed by the particular manager. What investment strategies are the managers following that allow them to be considered great in light of the recent financial crisis? What rules of agency theory are being utilized or are rules being ignored to allow these funds the success they have managed to gain? The research question relates to the mutual funds performance. What strategies have the managers followed to allow the fund to have above average performance in severe financial times? What is it about these funds that make them able to weather the storm? Speaking to Cambridge Energy Research Associates, Nouriel Roubini, Professor of Economics and International Business at New York University, Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University and Nariman Behravesh, Chief Economist

and Executive Vice-President for IHS Global Insight all agreed that this is the worst financial crisis since the Great Depression. Rogoff described the current recession as a once in a 50-year event. Behravesh called this financial crisis the Great Recession. Naimy (2008) reports that fifty-two million U.S. households and 88 million individuals invested in more than 8,100 mutual funds in 2006. The total investment was over $10.4 trillion. Based on the numbers, she states that mutual funds constitute a major financial asset for many investors and play a key role in todays investing world. Investors can help accomplish their investment goals with the well established mechanics of mutual funds. She cites professional investment management as vital to achieving results in todays complex markets. Mutual funds are a growth industry with many Americans financial future tied to the success and performance of this industry.

Investing Style The investing style classifications as assigned by Morningstar were used to group the 100 funds. Morningstar assigns investing style based on the underlying stocks in each fund using the price-to-earnings and price-to-book ratios in a mathematical calculation resulting in growth, value or blend classifications. Large-cap stocks are defined as the group that accounts for the top 70% of the capitalization of the Morningstar domestic stock universe; mid-cap stocks represent the next 20%; and small cap stocks represent the balance. World Stock is an international fund having more than 20% of stocks invested in the United States. World Allocation is a fund with stock holdings of greater than 20% but less than 70% of the portfolio where 40% of the stocks and bonds are foreign. Also, the fund must have at least 10% of its assets invested in bonds. Foreign large blend have a majority of their assets invested in foreign large-cap stocks, where

neither growth nor value dominate. Moderate allocation funds invest in stocks and bonds, with more than 50% in stocks. Conservative allocation funds invest in stocks and bonds, with just 20% to 50% in stocks. Long government funds have at least 90% of the bond portfolio invested in government issues with duration of greater than six years, or an average effective maturity of greater than 10 years. Intermediate government have at least 90% of the bond portfolio invested in government issues of a duration of greater than or equal to 3.5 years and less than or equal to six years, or an average effective maturity of greater than or equal to four years and less than or equal to 10 years. Convertibles have at least 50% of their assets invested in convertible securities. The 100 best time-tested mutual funds for these tough times include fifty-two in the large cap category. Large blend is the category capturing the largest number of funds based on Smart Moneys evaluation. Twenty-two funds are in the large blend category. Eighteen funds fall into the large growth category with twelve in large value. The moderate allocation category ties with large value with twelve funds making the top 100 list. Fifteen mid-cap funds make the list with nine mid-cap growth funds, five blend and one value fund comprising the mid-cap category. Nine small-cap funds are found in the top 100 category with four growth funds, four value funds and one blend fund making the nine. The remaining twelve funds making the top 100 list are world stock (3), long government (3), conservative allocation (2), world allocation (1), foreign large blend (1), intermediate government (1) and convertibles (1). (See Chart 1, below) Wu, Chang and Wu (2008) try to find how investors evaluate mutual fund performance, not only based on quantitative but also on qualitative criteria. They conclude that the most important criteria of mutual fund performance should be mutual fund style following with market investment environment. Investors should concentrate more on gathering information of

mutual fund style when selecting investment vehicles. They recommend that mutual fund issuers should try to provide more information related to mutual fund style and the investment environment. Comer, Larrymore and Rodriguez (2009) find that hybrid funds perform significantly better than the style benchmarks under weak stock market conditions. They define hybrid as both asset allocation and balanced mutual funds that hold a combination of equities, fixed income securities and cash in their portfolios. These funds engage in both security selection and market timing techniques. Using U.S. mutual fund date from 1984 to 2003, Kacperczyk, Sialm and Zheng (2007) found that mutual funds differ substantially in their industry concentration and that concentrated funds tend to follow distinct investment styles. Particularly, managers of more concentrated funds overweight growth and small stocks. Managers of more diversified funds hold portfolios that closely resemble the total market portfolio. Funds with the most concentrated portfolios performed better than funds with diversified portfolios. Their study supports active fund management since investment ability was more evident among managers holding portfolios concentrated in a few industries. Based on the top 100 funds, large cap funds were definitely the best choice to get through these past difficult days accounting for over half the funds in the list. Moderate allocation faired next in line with mid-cap growth close behind.

Chart 1 - Fund Category

foreign large blend conservative allocation moderate allocation world allocation world stock large blend long government intermediate government convertibles large blend large growth large value mid-cap blend mid-cap growth mid-cap value small blend small growth small value small value world stock small growth small blend mid-cap value mid-cap growth mid-cap blend large value large growth world allocation moderate allocation conservative allocation foreign large blend long government intermediate government convertibles

Fund Company Fifty-six fund companies are represented in the top 100 fund list. Capital Research and Management has the largest number of funds with eight making the list. These funds consist of large growth (2), large value (2), large blend (1), world stock (1), foreign large blend (1), and moderate allocation (1). Fidelity Management and Research Company has six funds on the top 100 list, five are large cap funds and one is moderate allocation. MFS Investment Management, T. Rowe Price Associates, and Van Kampen are represented with four of their respective funds making the top 100. MFS Investment Management has three of its four in the large cap category and one moderate allocation fund. T. Rowe Price Associates does well in the growth area with two small cap growth funds and one large cap. The remaining T. Rowe Price fund is in the moderate allocation category. Van Kampens funds all fall in the large cap area with three value and one blend fund. Federated Equity Management, Oppenheimer Funds Inc. and Value Line each have three funds on the list. These three companies have funds in various categories with

no particular pattern to their expertise. The remaining forty-eight fund companies all had either one or two funds that made the list. See Table 1. Table 1: Top 100 Funds by Fund Company Mutual Fund Companies Capital Research and Management Fidelity Management and Research Company T. Rowe Price and Associates Van Kampen Federated Equity Management Company Oppenheimer Funds Inc. Value Line Number of funds in top 100 list 8 6 4 4 3 3 3

Profitability The average ten year annual returns of the 100 funds ranges from -2.4% (large growth) to 11.7% (world allocation.) Interestingly, the fund with the largest ten year average return is the only one in its category. This world allocation fund is managed by Amhold and Bleichroeder Ave. The twenty-two large blend funds have an average ten year annual return of 1.5% with ranges from -1.2% to 6.9%. The eighteen large growth funds have an average ten year annual return of 1.2% with ranges from -2.4% to 4.3%. The twelve large value funds have an average ten year annual return of 2.3% with ranges from -0.1% to 4.0%. The large cap funds have the largest number of funds making the top ten list, but the smallest average ten year returns. The mid-cap funds have average returns ranging from 4.0% to 6.4%. The small cap funds have average returns ranging from 3.1% to 6.9%. The large cap categories are the only ones with funds having negative average ten year returns making the top 100 list. See Chart 2.

Chart 2 - Profitability of Top 100 Funds

convertibles intermediate long government foreign large blend conservative allocation moderate allocation world allocation world stock small value small growth small blend mid-cap value mid-cap growth mid-cap blend large value large growth large blend 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0%

Massa and Patgiri (2008) studied the impact of contractual incentives on the performance of mutual funds. They found that high incentive contracts induce managers to take more risk and actually reduce the funds likelihood of survival. These funds, even with high risk, deliver higher risk-adjusted returns. The 21-year cumulative return ranged from a high of 1,338.5% for Fidelity Contrafund (FCNTX), a large growth fund, to a low of 438.0% for Federated Equity-Income (LEIFX), a large value fund. The 21-year cumulative return average for large growth funds was 616.1%, large blend funds was 607.2%, and large value was 565.2%. The average for mid-cap blends funds was 799.5% and 730.7% for mid-cap growth. There was only one fund in the mid-cap value category with a 21-year cumulative return of 1,323.0%. Small growth, value and blend funds had a range from 804.3% to 451.6%.

Expense Ratio The expense ratio is commonly evaluated when ranking mutual funds. The average expense ratio for the top 100 funds range is 0.88 and ranges from 0.12 (large blend) to 1.40 (large growth and mid-cap blend.) The large cap funds have expense ratios averaging from 0.81 to 0.95 while the mid-cap and small cap funds have average expense ratios from 0.87 to 1.25 and from 0.84 to 1.34, respectively. Of the categories having three or more funds, small value has the largest average expense ratio of 1.34. The category long government has the lowest average expense ratio of 0.51. Large blend and large value funds have an average expense ratio of 0.81 while large growth is slightly higher at 0.91. Haslem, Baker and Smith (2008) investigate the relation between performance and expense ratios of 1,779 domestic, actively managed retail equity funds. They conclude that superior performance, on average, occurs among large funds with low expense ratios, low trading activity and no or low front-end loads.

Ten Year Star Rating According to Del Guercio and Tkac (2006), Morningstar Inc. is the market leader among retail investors choosing a source for their mutual fund investment selections. Several academic studies consider Morningstar as the most popular and best-known ranking service among investors (Blume 1998, Sharpe 1998, and Blake and Morey 2000.) As stated by Del Guercio and Tkac, the Morningstar star rating is a freely available, risk-adjusted performance measure that is updated monthly. The one-to-five star system is easy for the typical mutual fund investor to understand. The Morningstar star rating is based on its historical performance using loadadjusted returns based on return and risk relative to its peer group. Funds with risk-adjusted

ratings in the top 10% of their peer group are labeled five stars, the next 22.5% receive four stars, the next 35% receive three stars, the next 22.5% receive two stars, and the bottom 10% of funds in each peer group receive a one star rating. For the top 100 funds for tough times, The Morningstar ten year average star classification ranges from five stars to only two stars. Twenty-nine of the funds received the top five-star risk-adjusted rating, thirty-nine received a four star ranking, twenty-six funds were given three stars and four only had a two-star rating for the ten year period. Two of the top 100 funds have not been in existence for ten years so are not included with this measure. Both of these funds are mid-cap growth funds and have a three star rating for the previous five year period. Russel, 2006, evaluated the performance of Morning star to determine if any information valuable to investors was being provided. He found that very few funds were able to maintain their rating even for three months. Investors purchasing higher rated funds should not expect to earn superior returns. The ratings were not indicative of future performance but reflect historical superior risk adjusted performance. He concluded that the stars do not really foretell the future and may foster a false sense of confidence among nave investors.

Fund Size The fund with the largest amount of total assets, $131,401 million at May 31, 2009 is American Funds Growth Fund of America (AGTHX) which is a large growth fund with a tenyear average annual return of 3.9%. The second largest fund, American Funds EuroPacific Growth (AEPGX), had $79,557 million of assets with a ten-year average annual return of 4.5% and is categorized as foreign large blend. Interestingly, both these funds are managed by Capital Research and Management.


Average assets for the large growth funds are $14,922.4 million, large value is $8,562.2 million and large blend is $4,097.2 million. Each of these categories had 12 or more funds that were in the100 best time-tested mutual funds. Moderate allocation funds (12 in this category) had average assets of $11,379.6 million. The correlation between individual total fund assets and 10-year average return was positive, but not significant. Average total fund assets and 10year average return was negative, but not significant. See Chart 3. U.S. actively managed funds from 1993 to 2002 were examined by Yan (2008) to determine the effect of liquidity and investment style on the relation between fund size and fund performance. He found a significant inverse relation between fund size and fund performance, especially those funds holding less liquid portfolios.

Chart 3 - Top 100 Funds by Size ($000s)

$18,000 $17,000 $16,000 $15,000 $14,000 $13,000 $12,000 $11,000 $10,000 $9,000 $8,000 $7,000 $6,000 $5,000 $4,000 $3,000 $2,000 $1,000 $0

la rg la e b rg le e nd g la row m rge th id v m -cap alu e id -c ble a m p g nd id -c row ap th sm va a lu sm ll b e al len lg d sm row al t h w l va w o l m or rld ue od ld st co e a oc ns ra llo k er te cat va all io oc n ti in te lo ve a ati rm ng ll on e d g oca ia ov tio te er go nm n ve en co rnm t nv e e r nt tib le s


Activity Turnover measures how frequently the mutual fund holdings are bought and sold by the managers. A fund with a high turnover rate will obviously incur higher transactions costs than a fund with a lower turnover rate. Superior asset selection may generate higher returns to offset the transaction costs associated with higher turnover. Turnover was measured for the most recent year of the mutual fund. A large blend fund had the lowest turnover rate of 2% while a mid-cap growth fund had the highest rate of 215%. Large cap growth funds averaged 82.1% turnover, large cap value averaged 55.5% turnover and large cap blend had an average of 36.2%.

Liquidity The amount of cash on hand at the measurement date ranged from 0% for a large cap blend fund to 58.5% for a large cap growth fund. Average cash ranged from a low of 0.7% for long term government funds to a high of 31.0% for mid cap value funds. Kempf and Ruenzi (2008) examined the influence of the position of a fund within its family on its subsequent net-inflows. They found that reaching a top position within the family leads to large inflows, even beyond those expected, given the performance of the fund in its respective market segment.

Conclusion There is no doubt that the recent financial crisis has caused significant declines in many investors portfolios. The Smart Money article addressed the 100 great funds that were the best picks for these tough times. An evaluation of the 100 funds reveal that surviving the toughest of times may not mean the highest return in every single year, but it does mean earning a very


impressive 21-year cumulative return over the period. Large cap funds on average had the highest returns of all the funds when considering investing style, representing 52% of the funds in the top 100 list. Capital Research and Management was the best bet for mutual fund companies, having eight funds in the top 100. The funds had significant cumulative returns with every fund category showing excellent returns. Selecting funds with an expense ratio ranging from 0.12 to 1.40 would be a good choice considering all the other characteristics as well. Funds with a three star rating or better should be considered as potential candidates for the investors portfolio. Overall, the results show that even when times become very difficult investing in diversified mutual funds can generate adequate returns if the investor will stay the course over the long term.


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