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Something a bit different for today’s lesson of the week: We will break down a single article. The article is by Mark Hulbert son in this week’s New York Times. It is on mutual fund performance. One way to breakdown mutual funds is by whether they charge a load or not.
A load fund is one that charges a purchase (for front-end loads) or redemption (for back-end loads) fee. This fee is in addition to any regular managerial fee. It baffles me why anyone would invest in a load mutual fund. In a statistic that I find difficult to believe, Hulbert reports that 60% of funds invested in mutual funds are invested in load funds. (One explanation of this seemingly anomalous behavior is that many back-loaded funds waive their fees if the fund is held for a certain number of years. Thus for long term investors, this fee-no fee classification may be meaningless.)
That load funds underperform on an after-cost basis should not be surprising. What is more surprising is that they lag their open-ended brethren on a before-cost basis. After haranguing finance professors for not finding this underperformance before Carhart’s 1997 Journal of Finance article, Hulbert goes on to explain why the pre-fee underperformance was not found. The short answer is survivorship bias. Survivorship bias is the problem that looks at a sample and then goes back to find long run performance. This methodology misses those funds that go out of business.
Since more load funds fail than no-load funds, survivorship bias is more severe for load funds. Correcting for this survivorship bias leads to the finding by Morey (see SSRN link) that confirms this underperformance. Hulbert points out another overlooked fact about load funds that the loads may influence behavior. For example, you may be less likely to sell if you will be charged for selling.
In this light the fee acts to keep you invested rather than switching
into cash which is why a 1996 study by Boston’s Dalbar Inc. found that
load investors do better than no-load investors. While I do not doubt that
study, it would be better entitled “long-term equity investors do better
than undisciplined investors who switch back and forth from stocks to cash.”
The outperformance by the load investors is in spite of, not because of,
their choice of a load fund. http://www.nytimes.com/2001/07/08/business/08STRA.html
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=265133
Copyright FinanceProfessor.com 2001.
Permission granted for in class use.