Assessing Mutual Fund Performance When It Matters Most

by: Christopher Holt

Mutual fund detractors commonly cite their market under performance after fees.  Not content to blindly accept this argument, Professor Robert Kosowski of INSEAD asks how mutual funds perform in periods of economic expansion vs. economic recession. 

After completing what he calls “one of the most comprehensive examinations of the performance of US domestic equity mutual funds in recessions and expansions”, the professor concludes that US mutual funds actually perform better during recessions than they do during economic expansions.  In other words, mutual funds produce more alpha during recessions.  Furthermore, Kosowski contends that investors derive higher utility from a marginal increase in wealth during a recession - making mutual funds even better during bad times. 

States Kosowski:

“…the common finding of negative return performance at US domestic open-end mutual funds is attributable to expansion and not recession periods”

“Other things equal, an asset that does badly in states of nature like a recession, in which the investor feels poor and is consuming little, is less desirable than an asset that does badly in states of nature such as expansions in which the investor feels wealthy and is consuming a lot. Applied to mutual fund investors, this implies that investors are willing to trade off some overall performance or average return for good performance in particular states of nature.”

Several possible explanations are offered for this apparent anomaly.  One explanation is that periods of economic expansion are generally accompanied by asset inflows into mutual funds (thus increasing trading costs).  Another explanation is that inflows of new assets take time to invest - resulting in higher than normal cash balances (and commensurately lower returns).  A further, intriguing hypothesis is that corporate management teams tend to reveal all the good news they can during boom times, (leading to a high level of transparency) but release bad news only very selectively during recessions (leading to information asymmetry than can potentially be exploited by mutual fund managers).

But whatever the reason, mutual fund alpha seems to be asymmetrical.  While the author suggests investors might be able to exploit this finding, he acknowledges that they would also want to avoid equity mutual fund altogether at the beginning of a recession.

Therein lies the fundamental challenge in exploiting this anomaly: it requires market timing.  And if an investor was that good at market timing, she might as well just go long and short index futures.  Absent any market timing skills, the patient mutual fund investor is still destined to receive the average performance of mutual funds over both expansions and recessions.  In other words: market under performance after fees. 

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