The authors discuss how retail and institutional investors in similar investment products respond to investment signals, such as high fees and poor risk-adjusted performance. They examine the presence of greater monitoring and better performance for retail funds when an institutional twin exists.
When advisers manage multiple versions of a fund that are sold to different types of investors (e.g., retail and institutional), the funds are considered twins. The authors summarize the impact on the performance and governance of a retail fund that has an institutional twin. They find that having an institutional twin increases a retail fund’s risk-adjusted performance and offers greater monitoring, which results in reduced fees and improved managerial effort.
How Is This Article Useful to Practitioners?
The authors find that having an institutional twin for a retail fund with the same fund manager actually improves the retail fund’s risk-adjusted performance by 1.5% a year relative to a retail fund with no twin. The twin structure not only reduces the agency problems between mutual fund managers and investors but also results in stronger governance. The stronger governance is evident in lower fees, trading costs, and other implementation expenses as well as in less use of soft dollars and improved managerial efforts.
The authors also provide a positive perspective on recent legal and legislative developments related to excessive mutual fund fees. They suggest that the twin-fund arrangement provides better monitoring and thus justifies the fee differential. In the authors’ sample, institutional and retail twins have an average expense ratio difference of 0.42%, which is significantly smaller than the risk-adjusted excess performance of 1.5% for retail funds with an institutional twin.
How Did the Authors Conduct This Research?
The data consist of domestic U.S. equity mutual funds in the Morningstar database from January 1996 to December 2009, with a focus on 132 of 463 twin funds in which the institutional fund was created after the retail fund.
The authors use a regression to establish whether institutional investors are more sensitive to variables that predict returns than retail investors are. They then use propensity score matching techniques to establish improved risk-adjusted performance of retail funds after the creation of their institutional twins and compare them with a sample of funds that have no institutional twins but are otherwise similar. Finally, they examine the different channels through which monitoring by investors in the institutional twin fund could improve the performance of the retail twin fund.
The authors look for any statistically significant change in direct expenses by examining the expense ratio. For indirect expenses, they examine the change in a measure created by other researchers called the “return gap.” The return gap is a measure of a fund’s actual return minus the theoretical return on the fund’s most recently disclosed holdings net of expenses. The return gap captures indirect costs, such as brokerage commissions, trading costs, and other implementation costs. Finally, the authors use the active share measure to measure manager effort. Active share is the fund’s holdings minus the holdings of its closest benchmark. The results are consistent with their conclusions about increased monitoring.
It is a compelling argument that risk-adjusted performance increases for a retail fund with an institutional twin, but results may not be that statistically significant for fixed-income funds or other international mutual funds, including non-U.S. equity funds.