Author:Yifan Chen, PhD, CFA
The CFA UK Investment Studies Working Group summarises "Mutual Fund Performance and Flows during the COVID-19 Crisis" by Ľuboš Pástor and M Blair Vorsatz, from the Review of Asset Pricing Studies, December 2020.
Overview
One traditional perception on the popularity of active funds is that investors expect active funds to perform better during the most difficult recession time. The authors, however, present the contradicting evidence that active equity funds underperformed their passive benchmarks during the COVID-19 crisis of 2020. Among those active funds, funds with higher sustainability ratings and higher Morning star ratings performed better. Further, their finding on capital flows in and out of active funds suggests that investors remain focused on sustainability during the crisis.
What is the investment issue?
Although it is well documented that active equity mutual funds underperformed passive funds net of fees, it is less clear why active management is still popular when passive investment is easily available. One plausible explanation is that investors tolerate the underperformance of active funds because those funds could excel during downturns. Several previous studies (see, e.g., Moskowitz, 2000; Kosowski, 2011; Glode, 2011; and Kacperczyk, van Nieuwerburgh, and Veldkamp, 2016) that examine the fund performance during recessions support this traditional hypothesis.
Since the COVID-19 crisis is more severe than previous recessions and it contains a quick rebound in stock markets, the authors provide new evidence on the US active funds’ performance between February 20 and April 30, 2020. More specifically, they evaluate the fund performance during the crash and recovery stages of the crisis along with the pre-crisis period. Beside the overall performance of active funds, they examine the determinants of fund performance and analyse capital flows in and out of the funds. In particular, they consider the role of sustainability in addition to common indicators of funds such as investment style and Morning star rating.
The authors investigate how sustainability rating of fund affects fund performance and fund’s net flows. This could shed light on the conventional hypothesis that sustainability is a “luxury good” which implies that interest in sustainability should decline during crisis period.
Overall, this study provides new evidence on the performance of active equity funds during the crisis and enhances our understanding on how COVID-19 has affected financial markets. Beyond this unprecedented coronavirus crisis, actively managed fund performance in recessions deserves a future investigation.
How did the authors conduct this research?
The authors study the daily returns of 3,626 US actively managed equity mutual funds over the ten-week crisis period between February 20 and April 30, 2020. The crisis period is divided into crash (February 20 to March 23, 2020) and recovery (March 24 to April 30, 2020) stages. The findings on a pre-crisis period of October 1 2019 to January 31 2020 are also reported for a comparison purpose throughout this research.
A sample of 2,692,799 fund-level daily after-fee net return observations is collected from Morningstar Direct. Funds classifications are identified through the Morningstar Category, the Morningstar Institutional Category, and the Global Category. The benchmarks are the FTSE/Russell benchmark, the prospectus benchmark, and the S&P 500.
The authors evaluate fund performance by computing average differences between the fund’s net returns and its benchmark returns; and estimated intercepts from the regressions of excess net fund returns on factor returns.
They then run cross-sectional regressions with fund and industry controls to examine the determinants of fund performance including sustainability, exclusions, the growth investment style, and the Morning star rating. Fund performance is measured by benchmark-adjusted and factor-adjusted returns.
Robustness tests on above fund performance results are provided by considering the fund size, fund age, log returns, the effect of investment style, as well as sustainability and star rating sorting approaches.
Next, the authors look at the daily net fund flows at both aggregate and equal-weighted average levels. As before, they examine the impact of sustainability variables and star ratings on fund performance using similar cross-sectional regressions.
Finally, they investigate whether large outflows induced fire sales contribute to the fund performance during the crisis. In particular, they use regressions to check whether fund’s outflows today trigger fire sales today or in the following two days.
What are the findings and implications for investors and investment professionals?
The authors reject the popular hypothesis that active funds deliver better-than-benchmarks performance in recessions. Overall, the US active equity mutual funds underperformed as a whole during the COVID-19 crisis. 74.2% of the active funds underperformed the S&P 500 during the COVID-19 crisis. The average fund underperformance was -5.6% during the ten-week crisis period between February 20 and April 30, 2020, or -29.1% on an annual basis. When comparing active funds to their fund-specific style benchmarks, the authors report similar evidence. The poor performance of active funds was confirmed by negative factor-adjusted returns when computing fund alphas relative to five different factor model during the crisis periods. The annualized alpha ranges from -7.6% under the five factors of Fama and French (2015) plus momentum model to -29.1% under the CAPM. The portion of funds that exhibited negative alphas ranges from 60.4% under the four-factor Carhart (1997) model to 80.2% under the CAPM.
The authors also employ a difference-in-differences approach to show that fund benchmark-adjusted performance was significantly worse during the crisis than the pre-crisis period. While funds clearly underperformed during the crash subperiod, their performance during the recovery subperiod was mixed based on the poor benchmark-adjusted returns and good factor-adjusted returns.
The authors then examine the determinants of fund performance in order to understand why individual active funds performed differently during the crisis. Morningstar’s sustainability rating and past performance star rating are identified as two strongest performance indicators. Funds with a higher sustainability rating and those with a higher star rating delivered higher benchmark-adjusted returns than other lower rating funds within the same investment-style group. Interestingly, the sustainability rating effect was largely driven by environmental other than social and governance scores. They also present that growth funds generated higher returns than value funds on a style-adjusted basis during the crisis.
By analysing capital flows in and out of US active equity mutual funds, the authors demonstrate that investors were still committed to sustainability-oriented active funds during the large economic and health crisis. Funds that employed exclusion criteria and those with a high environmental score receive relatively more net flows than less sustainable funds within the same style group. The authors also show that investors prefer sustainable funds regardless of whether funds are active or passive and this preference is robust before and during the COVID-19 crisis. These findings imply that sustainability is a “necessity”, rather than a “luxury” suggested by the conventional view.
The limitations of this study and directions for future research
The scope of this study is limited by data availability issues. First, since the fund holdings data are only available on a quarterly basis, the authors could not address time-varying fund manager skill by separating stock selection from marketing timing during the COVID-19 crisis. Second, the fund turnover data from the SEC are available on an annual basis, hence they could not examine whether funds increase their turnover in 2020 given the profit opportunities created by COVID-19.
This study leaves plenty room for future research. For example, given the evidence that more sustainable active equity funds performed relatively better than less sustainable peers, it would be interesting to compare the performance of active sustainable funds and passive sustainable funds during and before the crisis. Broader crisis-related studies can investigate active bond funds performance, the sources of active funds’ underperformance, and the reasons behind investors’ demand for sustainability.
View the original paper on the Oxford University Press (OUP) Review of Asset Pricing Studies.
Original paper co-author: Ľuboš Pástor, Economist and Charles P. McQuaid Professor of Finance at Booth School of Business, University of Chicago
Original paper co-author: Blair Vorsatz, Finance PhD & MBA Candidate at Booth School of Business, University of Chicago
Review author: Yifan Chen, CFA, Associate Professor at Norwich Business School, University of East Anglia