Mutual fund intentional style drift: presence, motivation and performance impact

Chua, K 2018, Mutual fund intentional style drift: presence, motivation and performance impact, Doctor of Philosophy (PhD), Economics, Finance and Marketing, RMIT University.

Document type: Thesis
Collection: Theses

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Title Mutual fund intentional style drift: presence, motivation and performance impact
Author(s) Chua, K
Year 2018
Abstract Style drift is extensively practiced by active mutual funds in mature markets, although fund investors are generally unaware of the extent of this practice. When funds “secretly” invest in stocks that deviate from the fund’s declared investment strategy, fund investor’s risk and return expectations are disrupted and the problem of information asymmetry inherent in the mutual fund market exacerbated. The asymmetric information thus engendered not only limits the efficacy of fund performance evaluation but also renders fund investors to incorrectly assess the amount of risks they are exposed to and thus contributing to systemic risk.

Prior studies often assume that style drift is motivated by fund manager’s desire to increase her compensation linking to assets under management, usually without studying the fund flow-performance relation associated with drift behavior. In addition to the unbeknown distortion to the original risk-return profile on which fund investors bought units of the funds, the opportunistic drift behavior could also produce adverse impact on fund performance as fund managers who drift are likely to increase trading to exploit short-term returns to manipulate performance. This thesis interrogates the presence and pattern of intentional style drift in a market of exclusively in-house fund managers in China, where the fund market is more vulnerable to agency issues as the risk-taking behavior by fund managers is poorly understood. In particular, this thesis attempts to thoroughly investigate whether drift funds attract more subsequent capital inflows because the expected positive fund inflow is seen as the prime motivator for fund managers to strategically manipulate portfolio style and risk in a bid for higher relative performance ranking to maximize compensation. In this respect, we will uncover evidence to shed light on the motivation for style drift and also gain insights into the performance impact of this drift behavior.

This thesis proposes new metrics for detecting and ranking voluntary style drift for intentional style drift behavior and develops new conceptualization of style-drift tournaments to uncover style drift motivation and effects. We create an original yearly fund style index using the investible universe of 3,000 Chinese stocks, on the basis of the holdings-based approach which is rarely attempted in style drift literature. We then individually mapped 180,000 portfolio units in 274 open-end equity funds’ holdings against our customized style index. Our 18,600 fund-year drift observations show that style drift is prevalent.

We further test the relationship between style drift and subsequent fund flows and investigate how style drift behavior may be driven by fund managers’ pursuit of larger bonus compensation via competing for higher rank-order in 3 tournament contexts: equity fund market “universe”, funds of similar style “segment” and “family” fund. Our novel style drift-tournament model uncovers that style drift increases a fund’s net inflow, affirming that fund manager is motivated to maximize inflows to increase compensation through style drift. To maximize compensation, manager alters fund style to compete for a larger pool of investor through inter-fund company rank tournament than within fund family rank. In addition, larger funds have greater incentive to drift given the considerable impact of positive fund flows on their expected compensation.

On the basis of the evidence we uncover, we find that this agency-motivated style drift behavior is harmful to fund investors. Rather than just examining drift manager’s stock picking and market timing outcomes like most conventional studies, we propose a third alternative average style metrics to capture the likelihood of drift manager acquiring more expensive stocks when she exploits short-term returns to compete for new cash flows. Notably, we discover with new evidence that the active pursuit of short-term outperformance in drift funds raises total fund costs and affects manager’s ability to deliver productive fund returns.

Apart from bringing together a new collection of evidence and alternative explanations to the extant literature on mutual fund and a more limited one on style drift, this thesis also contributes to the finance literature by incorporating actual risk behavior to better understanding its direct implications on fund inflows and performance. This is in contrast to the conventional notion of risk taking by using the measure of volatility of returns. Our discoveries also substantiate the theoretical argument about the high levels of risk taking within fund organizations with internally managed funds. In the context of mutual fund market development and regulatory reform, this thesis calls for the strengthening of regulatory framework for the mutual fund market to protect and enhance fund investors’ welfare, and advancing the objectives of the financial institutions.
Degree Doctor of Philosophy (PhD)
Institution RMIT University
School, Department or Centre Economics, Finance and Marketing
Subjects Finance
Keyword(s) Style drift
Equity funds
AUM-based compensation
Net inflows
Holdings-based performance
Rank-order tournament
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Created: Thu, 26 Jul 2018, 14:02:12 EST by Denise Paciocco
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