Staying the Course: Mutual Fund Investment Style Consistency...

1. Discussion of: Staying the Course: Mutual Fund Investment Style Consistency... By Brown and Harlow For the FINANCIAL MARKETS CONFERENCE of the Federal Reserve Bank of Atlanta by: Wayne Ferson April, 2004 Carroll School of Management, Finance Department 140 Commonwealth Avenue, Fulton 330B, Chestnut Hill, MA. 02467-3808 (ph: 617-522-6431), www2.bc.edu/~fersonwa.

2. 3 MAIN HYPOTHESES: Fund "Style Consistency" Related to: (1) Fund Costs (2) Performance (3) Persistence in (Future) Performance FINDINGS: Strong " - " (Turnover) (Expense Ratios) Weak " + “ Weak " + " (Stronger than α) Overview

3. Hypothesis 1: Relation Between Style Consistency and FUND COSTS Edelen (JFE 99) Fund Flows => All Turnover is NOT Created Equal! TURNit = a + bi FLOWit + eit TURN= Nondiscretionary + Discretionary (Flow-related (Unrelated to flow) Turnover) He Finds ( - ) ( + )

4. Hypothesis 1: Relation Between Style Consistency and FUND COSTS My Proposed Refinement: You have to Trade to be Style-Consistent! Let STURNit = Turnover of the Style Index for Manager i at time t. TURNit = a + bi FLOWit + ci STURNit + eit TURN = Nondis. + Style-tracking + Disc. (Flow-related) turnover Predicted ( - ) Per |ci-1|0 ( + ) Relation to Performance?

5. Hypothesis 2: Relation Between Style Consistency and PERFORMANCE A Weak Positive Relation R2 measure of Consistency gives Stronger results than TE: Table 4, Panel A: Correlation {Consistency, Performance}  0.33, Any year = 0.11, Overall  Fraction of Cross-sectional Variance in Performance Associated with Style Consistency:  10% , Best year  1%, Overall. Diametrically Opposed to "Modern Portfolio Management" View (e.g. Grinold and Kan, 1995) Essence of MPT: It takes Tracking Error to Find Alpha

6. Hypothesis 2: Relation Between Style Consistency and PERFORMANCE, cont...  What About Variation in Style Loadings? • Intuitively Related to Style (in)consistency • Directly Related to Average Returns: r = α + β F + u, β is random  E(r) = α + Cov(β,F) + E(β)E(F) Cov(β,F) = Style inconsistency Measure Measured Average Performance = α + Cov(β,F) • Ferson and Warther (FAJ 96) Show Fund FlowsCov(β,F) < 0 !  Flow-related Cov(β,F) MOTIVATES Second Ho Mechanically.  Important to look at Flow-related Effects!

7. Mutual fund sales, conditional betas,and market indicators Source: Ferson and Warther (FAJ 96), Table 3. Panel A: Mutual Fund Sales and conditional betas ΔConditional Beta = b0 + b1 ΔSales Panel B: Mutual Fund sales and market indicators ΔSales = b0 + b1 Δ(D/P) + b2 ΔTB

8. Hypothesis 2: Relation Between Style Consistency and PERFORMANCE, cont... • A Conditional Performance Evaluation (CPE) View Says some of this may be Spurious! •Assume Semi-strong Efficiency per Fama (JF 70) •Public Information, Z • Any Style Inconsistency that is known given Z is irrelevant to Investors (like M&M). •CPE Measures Conditional Performance, Given Z, α(Z): •Ferson and Schadt (1996) Show: E(α(Z))  αUNCOND - Cov{β(Z),E(F|Z)}  Would a (CPE) Analysis "Explain Away" the Weak Positive Relation Found Here?

9. Hypothesis 3: Relation Between Style Consistency andPERSISTENCE Persistent Cov(β,F) Could Cause This! Look at Conditional Measures! • Persistence: Good or Bad? Separate positive from negative past-alpha observations

10. FINAL MISCELLANEOUS SUGGESTIONS:  What are the "Leakages" Related to? •MPT says alpha requires Tracking Error •Managers' "GROSS" ability versus Investors‘ Realizations?  Look at performance GROSS of: { Expenses, Turnover * Transcosts }  LOAD FEES: •Used to Attract Low-TURNover investors? May lower cost of Style-consistency. Try the averge fund in a style cell as alternative Style benchmark