Mutual fund investors: Don’t shoot for the stars

ANN ARBOR—Top-performing or “star” mutual funds may be a boon to their fund families, but investors should beware of mutual fund companies that employ “star-creating” strategies, say University of Michigan Business School researchers.

While a star fund can cause strong, positive “spillover” effects resulting in greater cash inflow to other funds in its family, it is usually mutual fund families with poor investment abilities that adopt a star-creating approach, according to a new study forthcoming in the Review of Financial Studies.

“Investment strategies that are effective in generating stars—by having a large number of funds pursue very different investment strategies so that by chance one might emerge as a star fund—are also the ones associated with lower average performance,” said Lu Zheng, assistant professor of finance. “A star-creating strategy, presumably targeted to less-informed investors, does them no favor.”

In their study, “Family Values and the Star Phenomenon,” Zheng and Michigan Business School colleagues Vikram Nanda and Z. Jay Wang examined the performance of all diversified U.S. equity funds over a seven-year period in the 1990s. They define a star fund as ranking among the top 5 percent in performance in the previous 12 months (the empirical results remain similar when they alternatively define a star fund as a Morningstar 5-star-rated fund).

The researchers found that new money growth for families with a star fund is, on average, 4.4 percent higher on an annual basis than for families with no stars. In other words, a star family attracts an average of $181 million more than a non-star family on a yearly basis.

“Compared to a stand-alone star fund, an average-sized family receives an increase in fund inflow that is more than three times larger,” said Nanda, associate professor of finance. “The magnitude of the spillover effect is, therefore, substantial and could well affect fund families’ investment strategies and, thus, decisions regarding the number of funds in a family and the introduction of new funds.”

According to the study, mutual fund families with more member funds and higher variation of returns across its funds are more likely to produce stars. However, such families underperform the market by 3.6 percent per year.

On the other hand, a relatively low variation in cross-fund returns may indicate sharing of information and coordination among member funds, the researchers say. As a result, these families tend to perform better—with or without a star fund.

The study shows that a star fund is a strong indicator of ability and future performance only when the fund family’s ex-ante probability of producing a star is low. But families that deliberately pursue a star-creating strategy perform worse than those that follow a focused strategy.

“Our results indicate that a star portfolio does not outperform a diversified portfolio,” said Wang, a doctoral student in finance. “Families with low investment ability may have a greater incentive to choose variance-increasing strategies in order to generate stars. Hence, to mutual fund investors that naively chase the glitter of stars—don’t.”