A recent paper by a group of three finance professors backs up with fact what many have suggested for years:  too-fluid mutual funds cost investors more than they gain, according to The New York Times. The study, entitled “Does Motivation Matter when Assessing Trade Performance? An Analysis of Mutual Funds,” examines four model funds—each based on manager motivation—using performance data between January 1980 to December 2003.

Gordon J. Alexander, of the University of Minnesota and colleagues from the College of William and Mary, Scott Gibson and Gjergji Cici, aimed to prove that managers’ motives for buying or selling certain stocks affects the funds’ long term performance. 

The first two portfolios compared managers who are “value-motivated” to purchase stocks they believe are set to rise to accommodate a large inflow of cash, and those who are motivated to sell after a large net outflow.

The simulated portfolios were rebalanced quarterly.

During the timeframe examined, the value-motivated-buy fund outperformed the stock market by 2.8%, while the sell-portfolio returned 0.7% less than the benchmark.

In the second set of models, the professors assumed managers were buying and selling solely to meet investor demands.

This time, managers who make a liquidity-motivated buy to accommodate big inflows of fresh cash did close to 2% worse than those who sold simply to satisfy investors’ redemption demand.

Because these numbers reflect performance only, the study noted, value is further eroded when transaction, management and other costs are factored in. Most importantly, those results affect all investors in a fund, not just those who choose to add money or redeem their investments.

Although closed-end funds do not face these redemption problems, they are no panacea, according to Gibson. That model, which restricts flows even when the fund is performing poorly, Gibson said,  “helps entrench poor-performing managers.”

The fund that serves its long-term investors—therefore the majority—best is the fund that discourages the short-term mentality through fees and penalties. “If you’re a long-term investor [such disincentives] are your best friend,” he said.

The staff of Money Management Executive ("MME") has prepared these capsule summaries based on reports published by the news sources to which they are attributed. Those news sources are not associated with MME, and have not prepared, sponsored, endorsed, or approved these summaries.

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