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Fund of Funds Selection of Mutual Funds
Abstract
Managers of Fund of Funds have access to information not available to the general public in evaluating funds from their own family. However, they may have family or self-serving motives that can hurt shareholder performance. By examining a history of individual transactions of funds of funds, we show that managers of Fund of Funds despite access to non-public information select individual funds that underperform random selection. Much of this underperformance is shown to be explained by managers satisfying a specific set of family and management goals. Fund of Funds that invest exclusively outside their fund family do not face these family and management goals and they outperform Funds of Funds then invest inside the family.
... In particular, PB bias is not just a repackaging of Sialm, Sun, and Zheng's (2019) finding of a local bias in FoF portfolios, as we continue to find a strong preference for PB hedge funds even when there are no local hedge funds among them. Similarly, PB bias is also not merely a manifestation of FoFs' style focus or internal investments in sibling hedge funds (Bhattacharya, Lee, and Pool 2013;Elton, Gruber, and de Souza 2018). In fact, PB bias is stronger among hedge funds that are outside the FoF's local area and style expertise, where information frictions are likely to be greater. ...
... Thus, the results here also assure that PB bias is not driven by FoFs investing internally in their sibling hedge funds (Bhattacharya, Lee, and Pool 2013;Elton, Gruber, and de Souza 2018 Table 3 continue to show a significant PB bias even after purging the effect of style focus. ...
... In contrast, funds that lend securities instead of selling them (short) underperform otherwise similar funds according to Evans et al. (2017). Elton et al. (2018) show that some funds invest in other actively managed funds and that these funds underperform when investing within the fund family. Similarly, Sherrill et al. (2017) show that around 38% of all actively managed mutual funds hold exchange-traded funds (ETFs) in their portfolio and that funds excessively investing in these passive investments underperform. ...
... 10 As already reported by Chen et al. (2013) mutual funds engage in short selling of equity far more than one would expect, resulting in an average short exposure of more than one million USD. According to Sherrill et al. (2017) and Elton et al. (2018) mutual funds tend to hold other actively managed funds or ETFs, which we also find in the portfolios of our sample funds with on average of almost 1.9 million USD. ...
This paper is the first to identify and classify nearly all investment instruments held by equity funds by investigating their portfolio holdings. This enables us to analyze the effects of long and short exposures from different complex instruments including short sales, options and futures but also previously neglected derivatives like warrants and units on funds’ risk, performance and other characteristics. These analyses are of general interest, especially in the light of ongoing discussions regarding further regulation of complex instrument use by mutual funds. Our empirical analyses document that on average more than 40% of funds use complex instruments. However, relative to their total assets, funds’ average exposure from such positions is very small with values below 2%. Consequentially, the effects of instruments are often weaker than suggested by previous research or even show opposite directions.
Using the setting of funds of hedge funds (FoFs), we show that prime brokers (PBs) facilitate investors’ search for informed hedge fund managers. We find that FoFs exhibit PB bias, a disproportionate preference for hedge funds serviced by their connected PBs. This PB bias is stronger when the cost of hedge fund due diligence is higher relative to capital and when the FoF’s management firm generates higher prime brokerage fees. PB bias also predicts FoF performance: the highest PB-bias quartile outperforms the rest by 2.08%–2.45% per annum after adjusting for differences in their risks.
This paper was accepted by Victoria Ivashina, finance.
Just over 20 years have passed since the publication of Mark Carhart’s landmark 1997 study on mutual funds. Its conclusion—that the data did “not support the existence of skilled or informed mutual fund portfolio managers”—was the capstone of an academic literature, which began with Michael Jensen in 1968, that formed the conventional wisdom that active management does not create value for investors. We review the literature on active mutual fund management since the publication of Carhart’s work to assess the extent to which current research still supports the conventional wisdom. Our review of the most recent literature suggests that the conventional wisdom is too negative on the value of active management.
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