HOME Recent Events RMI in the News ALUMNI
  Issue 3 | Archive  

May 2010

Better Mutual Fund Managers

A paper by Dr. Meijun Qian, NUS Business School

In a forthcoming paper "Stale Prices and the Performance Evaluation of Mutual Funds" to be published in the Journal of Financial and Quantitative Analysis, RMI affiliated researcher Dr. Meijun Qian argues that mutual fund or unit trust managers may have better stock picking abilities than what has been previously documented. She finds mis-estimation could be an additional potential reason for low alphas, together with the existing high trading costs and other expenses that are reducing surplus funds returns.

In an open end mutual fund, there is a well known-problem of stale pricing - the fund share prices (NAV) may differ from the true value of the underlying assets. This incongruity occurs because the share prices set by funds at the end of each day are explicitly based on the last price. In case of thinly traded and/or international assets, the last available price could significantly deviate from the underlying asset value. Therefore, the observed returns on mutual fund shares are no longer random. In the absence of randomness in returns, the application of the Capital Asset Pricing Model (CAPM) is likely to generate statistical bias in fund performance evaluation. Furthermore, the returns are now partially predictable. Anyone intentionally or unintentionally trading the mutual fund shares can reap riskless profits due to the return predictability. These profits then manifest as a cost to existing shareholders and dilute the long term fund returns.

The author develops a model that can estimate the stock picking ability of fund managers free of statistical biases and dilution problems. Empirical implementation of the model shows that the average mutual fund performance is about 40 basis points higher than previous estimations using traditional models - these performance improvements are mostly due to funds that suffer from severe problems of stale pricing.

In addition, empirical tests show that while the statistical bias may be negligible, the dilution affect is statistically and economically large. In funds with severe stale pricing, the dilution effect can add up to 90 basis points a year.

While the estimated fund alpha from the model she used is still insignificantly positive, it is no longer negative. Thus, the results shed some light on the previously reported puzzling phenomenon that funds receive billions of new flow each year and control trillions of assets despite that they underperform benchmarks, resulting a negative alpha.

Dr. Qian's study suggests that both investors and fund managers should be cautious of the stale pricing problems. As long as the money flowing in-and-out of the funds is correlated with fund returns, irrespective of whether it is from arbitrageurs, the dilution effect will exist. Therefore, prohibition of timing arbitrage on stale pricing is likely to be inefficient in eliminating dilution effect completely. Rather, reducing stale pricing through fair value pricing should be encouraged, not only to protect the interest of long term investors but also to aid fund and portfolio managers.

Back To Newsletter

Published quarterly by Risk Management Institute, NUS
Editor: Ivy Wang (rmiwy@nus.edu.sg)