Aurora Borealis
1 September 2014 CFA Institute Journal Review

Investing in a Global World (Digest Summary)

  1. Biharilal Deora, CFA, CIPM

Previous empirical research has shown that among international markets, those outside the most developed nations are less efficient and thus more exploitable by active fund managers. The authors find little evidence of skill by US investors in international markets generally, but they do find evidence of high alpha in the tails of the distribution.

What’s Inside?

The authors find little evidence of superior performance in actively managed funds and discover that very few funds have managed to generate superior performance in international investing. Using simulation draws, they find that the performance of these funds is largely the result of luck and not security selection. Nevertheless, these funds may be able to generate alpha in the future.

How Is This Research Useful to Practitioners?

US-registered active retail mutual funds and institutional investors have combined assets of $2.1 trillion with a mandate to invest in global equities. Much empirical research has been done on the performance and persistence of funds that invest in US equities, but funds with global mandates have received little academic attention. Although the authors’ sample consists only of US-registered funds, their test results are applicable even to funds from non-US sponsors; thus, the results are useful for a global audience.

Approximately 8% of 777 institutional and 6% of 655 retail funds in the authors’ sample generated statistically significant positive alpha over the study period, which can be attributed to stock selection. Most of these institutional funds are relatively small. The authors suggest that for the average investor, passively managed funds are better for diversification than actively managed funds; active management has a higher expense ratio without generating superior returns.

How Did the Authors Conduct This Research?

The authors use a sample of 1,218 institutional funds from Informa Investment Solutions (IIS) for the period of 1991–2009. The IIS database contains the list of actively managed US-registered global funds. Another sample of 1,019 US-registered retail funds is extracted from the CRSP Mutual Fund Database for the period of 1987–2009. The sample of funds is heterogeneous in terms of the countries invested in. To compare the performance with benchmark indices and to manage such a large list of indices, the authors map the institutional and retail funds to Morgan Stanley Capital International (MSCI) indices. For a regression analysis, they use the Fama–French three-factor model and the Carhart four-factor model. They construct separate factors for developed and emerging markets and use both in their factor models; the results are presented together. To assess whether generated alpha is the result of skill or luck, the authors draw 5,000 simulations against returns.

Abstractor’s Viewpoint

In regard to developed international markets, one potential reason that smaller institutional funds generate superior alphas in international investing is the higher impact and trading costs in developing markets. The authors offer the scope for research scholars to shed some light on this issue and study the relationship between fund size and alpha in emerging economies.

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