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1 February 2013 CFA Institute Journal Review

Reprint of Investors’ Distraction and Strategic Repricing Decisions (Digest Summary)

  1. Marc L. Ross, CFA

Reviewing 20 years of mutual fund price data, the author analyzes investors’ reactions to changes in expense and price information. Performance tends to blind investors to cost information until such data become more readily available to retail investors. He also reviews how investment companies time fund repricing to exploit time variations in price and performance. He finds an inverse correlation between the quality of fund company governance and opportunistic repricing.

What’s Inside?

Mutual fund pricing has become a popular topic of study. The author reviews price data from 1986 to 2006, and he concludes from his analysis that investors tend to focus on performance at the expense of pricing information, which has been less readily available to the retail investor and more expensive to obtain. When expense ratios and other price data are more readily available at a lower cost, investors become more sensitive to them in their decision-making process. The author also reviews fund company repricing and finds opportunistic behavior among mutual funds that are trying to maximize investment flows that result from time variations in investors’ price and performance sensitivity.

How Is This Research Useful to Practitioners?

Analysis of statistics may appear speculative and indicative of data mining to some investment professionals. But according to the author, price discovery in the mutual fund arena has led to a change in performance sensitivity and cost sensitivity for mutual fund investors. He rigorously analyzes data from a 20-year period, during which time pricing and performance information became more transparent. This time span presents the challenge of how best to put all of the data on an equal footing. Investors have been sensitive to performance but less so to expense ratios, particularly if the fund is a good performer. This lower sensitivity would cause investors to overlook higher fees or see them as justification for performance.

Over time, this view has changed as pricing information has become more readily available and more affordable. Mutual fund companies take advantage of occasions when investors are less sensitive to performance and expenses (time-series variations) in order to time repricings to maximize mutual fund flows. As the author demonstrates, such conduct is indicative of lower-quality governance practices.

How Did the Author Conduct This Research?

The author reviews the relevant literature on the subject. For his own research and analysis, he uses data from the CRSP Survivorship-Bias-Free Mutual Fund Database, which contains net asset value, return, and fund characteristic information. The period of investigation is from 1986 to 2006. The author samples a homogeneous group of funds that follow the investment objectives of aggressive growth, growth, and growth and income.

To gauge price and performance sensitivity, he models net fund flows as a function of past performance and expenses. Net flows are the percentage growth of total net assets adjusted for fund returns net of expenses. The author calculates these on a monthly basis and aggregates them over the fund’s fiscal year to minimize approximation errors resulting from the timing of investment decisions. Net flows are capped at 5% to eliminate outliers that could result from corporate actions at the fund company, such as spin-offs and mergers. To measure performance, he examines the fund’s fractional rank in the previous fiscal year, which represents its performance relative to other funds with the same investment objective in the same period. He performs this examination both gross and net of fees as a robustness check.

The author uses quadratic and dummy variables to test for the stickiness of mutual fund flows and the flow/performance relationship. The results seem to support the existing literature and evidence indicating that expense ratios and mutual fund flows are often negatively correlated. Past performance of top-performing funds tends to distract investors from those funds’ higher expense ratios. The evidence also supports the proposition that fund visibility or transparency increases investors’ price sensitivity.

To conclude, the author tests the relationship between mutual fund company repricing decisions and governance quality through a regression model using Morningstar’s Stewardship Grade and the change in expense ratios. The grade is a synthetic score that combines evaluations in five different areas: regulatory history, board quality, manager incentives, corporate culture, and fees. The result is a negative coefficient illustrating that better governance is associated with smaller expense ratio increases. Some fund companies exhibit opportunistic behavior in their pricing practices because of investors’ changing sensitivities to performance and price data.

Abstractor’s Viewpoint

The author’s research is a study in behavioral finance, as much from the perspective of the retail investor as from that of the fund companies themselves. Investors are sensitive to performance but also to pricing information, especially since the latter has become more transparent and less expensive to obtain. Fund companies’ opportunistic behavior takes advantage of the relationship between changes in price and performance sensitivity. Subsequent changes in funds’ expense ratios to maximize fund flows are the end result, particularly among companies in which evidence exists of lower-quality governance practices.

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