Question

Discuss the consistency of mutual fund performance results, as studied by Goetzmann and Ibbotson (1994) and Malkiel (1995).

Answer 1

Goetzmann and Ibbotson (1994) examine the performance of equity mutual fund portfolios over the period 1976-1988. They use raw and risk-adjusted returns and the prior two years’ performance to predict the performance of the subsequent two years. Their results support the repeat winner hypothesis. Even more dramatic results are obtained when the researchers try to confront the potential survivorship bias of their results. They categorise funds into high-variance and low-variance and then winners and losers are ranked and determined over one-year periods, and then ranked again over the subsequent one-year periods. The results support the repeat-winner hypothesis.

Malkiel (1995) finds reversals in two of the years following Brown’s and Goetzmann’s sample period, which suggests that the probability of reversal is high and confirms that the strongest evidence for repeat performance is over the late 1970s and early 1980s.He also states that investors may gain when selecting funds by relying on recent good performance and the persistence may have a seasonal character.

This study applies the “winner–winner, winner–loser” methodology developed by Brown and Goetzmann, Goetzmann and Ibbotson, and Malkiel to test for short-term performance persistence in international equity mutual funds over the 20-year period from 1977 to 1996. Persistence tests are applied to a database consisting of all international equity funds in existence during this period, varying from a low of 11 (1977) to a high of 473 (1996) funds, reflecting the extremely rapid growth of this asset class over the last 20 years. The authors are not aware of any other persistence studies of international equity funds. The results show statistically significant performance persistence for 1-year holding periods, but no persistence for 2, 3 or 4-year periods. For 1-year periods, overall, performance persistence is statistically significant at the .001 level. This leads to the conclusion that international equity mutual funds exhibit strong performance persistence for short-term (1-year holding periods), but persistence generally fades after the first year. These results are generally consistent with results found by other researchers using this methodology. Survivorship bias is a concern in virtually all time series studies of mutual fund returns. This bias is minimal in this study because each new fund is added to the database, merging funds continue to be included and adjustments are made for funds that cease operations. The only bias is that if any fund closed and did not merge with an existing fund, that fund would not have returns to be included for the future periods. Only 28 funds ceased operations over the 20-year period during which 490 new funds were introduced.