End-of-year adjustments can be costly

Mutual funds

December 14, 1997|By Bill Barnhart | Bill Barnhart,CHICAGO TRIBUNE

After last month's stock market plunge, I suggested that market sell-offs in the latter part of the year may reflect efforts by mutual fund managers and other institutional investors to bail out before they lose annual bonuses accumulated in the strong market earlier in the year.

A reader sent me the following "dumb question" in response: "If the bonuses of portfolio managers contributed to the recent upheaval of the stock market, why hasn't the Securities and Exchange Commission scrutinized the bonus arrangement system? It seems the system does not play fair with the average investor willing to stay in for the long haul."

I'm not sure the Securities and Exchange Commission is the place to look for redress. In the immortal words of the late Walt Kelly's Pogo, "We have met the enemy, and he is us."

Investors upset by October's plunge may be reaping what they have sown in their fascination with short-term mutual fund performance data, according to recent academic research.

Cash flows into mutual funds depend heavily on calendar-year fund performance -- especially the ability of funds to outperform a widely quoted market benchmark, such as the Standard & Poor's 500-stock index.

In the third quarter, ended Sept. 30, 80 percent of the actively managed domestic equity mutual funds beat the S&P 500 -- the largest percentage of funds doing so since 1979, according to Morningstar, the Chicago-based mutual fund research organization.

In several previous quarters, active fund managers on average lagged behind the S&P index.

The extraordinary third-quarter results presented a powerful incentive for active fund managers facing critical year-end performance reports to lock in gains and avoid pitfalls in the last three months of the year.

Funds lock in above-market gains by selling stocks and either building cash reserves or adjusting the fund to simply mimic the S&P 500 index. This adjustment can be accomplished directly or indirectly through the futures and options markets.

Judith Chevalier of the University of Chicago Graduate School of Business and Glenn Ellison of the Massachusetts Institute of Technology, in a paper for December's Journal of Political Economy, describe statistical evidence of this locking-in tendency.

The tendency is strongest among younger funds trying to build an investor and asset base, they found.

"The [cash] flow performance relationship, viewed as an incentive scheme, may induce mutual funds to manipulate the riskiness of their portfolios towards the end of the year," they write.

"Suppose (a) fund were 8 [percentage] points ahead of the market by the end of September. Inflows would be only slightly higher with a small improvement in performance, but would be sharply lower with inferior performance. Hence, the fund benefits from playing it safe and locking in gains throughout the fourth quarter."

While financial press headlines portray riskiness during periods of market volatility, investors may be harmed as much by a sudden bout of risk-aversion among professional portfolio managers.

What's more, long-term fund investors don't get what they pay for when managers bail out. "If you pay higher fees for active fund management than a passive index fund, the reason you're [paying] this is you think there's some benefit to be gained from the actively managed fund," Chevalier said.

"So, to the extent you think the manager has an incentive to lock in [fund performance], I'm not sure you would be any less unhappy about that than you would be about a manager who has an incentive to roll the dice. Why would you be buying an actively managed fund if you didn't want [the manager] to roll the dice just a little bit?"

The problem centers on the separate interests of fund managers and fund investors. Except for bragging rights and routine monitoring, most investors already in a mutual fund have little reason to care about their fund's quarterly or calendar-year performance.

Sure, if your fund is well below average over many years, you probably would switch to another. But most funds are average performers over time, coming close to the stock market benchmark, regardless of whether they are actively managed.

Aggressive switching among funds and obsessive interest in short-term performance is not only pointless but also counterproductive. The short-term emphasis leads fund managers to dwell on short-term trading tactics, such as year-end bailouts, instead of your actual investment goal, which may be many years in the future.

Short-term performance data are vital, however, for funds trying to attract investors and cash. The direct cause-and-effect relationship between above-average investment performance in the latest calendar year and increased cash flow in the subsequent year is undeniable.

Publicity in the financial press, celebrity status for fund managers and cash flow into funds all depend on above-average performance at the turn of the year, the time when many investors make decisions about where to place their dollars.

The emphasis on short-term performance data, though enormously popular, is one more example of how mutual fund marketing works against the interests of a fund's existing shareholders.

Existing shareholders pay for -- but get virtually no benefit from -- marketing expenses incurred by their funds.

Likewise, existing shareholders pay for -- and probably get no benefit from -- the end-of-year investment manipulations by a fund manager aimed at end-of-year performance reports.

Pub Date: 12/14/97

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