CRITERIA FOR INVESTING IN INTERNATIONAL MUTUAL FUNDS

This article describes advantages and disadventages of investing in mutual funds, as well as what to pay attention to for investors when selecting mutual funds. The main purpose of mutual fund investors is usually receiving a return which is above or at least close to the mutual fund’s benchmark. Consequently, investors want to identify and invest in those mutual funds which show these patterns in the future. Main motivation of this study is that investors usually seem to underestimate or even ignore several important criteria. These are for example the costs associated with mutual funds, governance issues or the active share of mutual funds.

Introduction

The yearly investments in mutual funds amount to trillions of USD. International mutual funds are an important investment opportunity with a lot of advantages. However, there are certain problems regarding how to choose a mutual fund that will give high returns on investment. This article describes what to pay attention to for investors when selecting mutual funds.

The purpose of the article is to demonstrate the factors that should be recognised when choosing international mutual funds. Theoretical and methodological basis of the research is papers and articles of various researchers devoted to the subject of mutual fund investment and analysis of mutual fund profitability.

The article consists of two chapters. The first chapter gives a brief insight about the types as well as advantages and disadvantages of international mutual funds. In the second chapter, the paper discusses points of attention and potential problems, factors affecting the performance of mutual funds. Our work considers the standards of the success of the fund.

Chapter 1. Advantages and disadvantages of mutual fund investment. International mutual fund classification.

This chapter describes the advantages and disadvantages of mutual funds. Firstly, it is necessary to explain the meaning of a fund. Mutual funds are financial intermediaries, which provide the benefits of capital contribution, process information, discover the selection of investments, and invest money on behalf of the individual investor. Fund manager minimizes the risk of capital investment by making a choice of the portfolio of the funds.

Mutual funds offer different ways to earn money. Firtsly, by dividend payments. A fund may earn income from dividends on stock or interest on bonds. The fund then pays the shareholders nearly all the income, less expenses. Secondly, profit may come from capital gains distributions. The price of the securities in a fund may increase. When a fund sells a security that has increased in price, the fund has a capital gain. At the end of the year, the fund distributes these capital gains, minus any capital losses, to investors. Finally, increased net asset value. If the market value of a fund’s portfolio increases, after deducting expenses, then the value of the fund and its shares increases. The higher net asset value reflects the higher value of your investment.

The main advantages of the investments in mutual funds are portfolio diversification, a professional asset management, liquidity, and generally an overall capital structure. The diversification leads to risk reduction, that individual investors can hardly get by investing their assets in a single stock. The professional portfolio management is important, because individuals are often not able to scan the entire market and identify "good" investment opportunity. Liquidity is related to the fact that investors can buy and redeem fund shares daily, thus providing a high level of adaptability to changes in the market.

However, mutual funds have a number of drawbacks. For example, there are only a few (if any) active mutual funds that can do better than their benchmark after costs have been deducted. Aside from this, especially in funds linked to the bank groups or publicly held mutual fund families, the conflict of interest hypothesis can cause a number of serious problems.

The conflict of interest can be summarized as a situation in which a party can achieve a profit by doing the action harmful to the partner. The action requires information asymmetry. In our case the mutual fund manager has superior information against the mutual fund investors. The conflicts of interest in mutual fund can result for example in adverse features such as a lack of disclosure to investors, tax inefficiency, inadequately high fees and window dressing.

International mutual funds are the funds that invest only in assets located outside the home country. International mutual funds ensure that you don't have to deal with the time consuming and complex task of picking individual foreign stock on your own. A fund manager does that for you with the fund's investment portfolio comprised of international corporations.

The advantages of the international mutual fund include low minimum investment amount, absence of necessity of creating a brokerage account and a high percent of historical return.

In general, the international funds are divided into three main types based on where they invest in: global, regional, and sectoral mutual funds.

Global international mutual funds invest in stock from all over the world and not just a country. For example, PGIM India Global Equity Opportunities Fund is investing in stocks from the US, France, Singapore, Switzerland, and more through PGIM Jennison Global Equity Opportunities Fund.

2. Regional international mutual funds invest in the stock market where there is only one country or region. Index funds are a great example. They track one index from a single market (country). For example, Motilal Oswal S&P 500 Index Fund which invests in all the stocks from the index S&P 500.

3. Sectoral mutual funds are highly specialized and look to gain from the benefits of a particular sector. For example, health care, power and others.

Chapter 2. Factors to consider when investing

To make the lives of investors easier, there have been introduced ratings of mutual funds. Two common types of ratings are fund ratings and credit ratings, which display significant distinctions. While a credit rating is forward looking and measures an absolute default risk, fund ratings are commonly only backward looking and measure the past performance relative to funds in a peer group and do not incorporate qualitative facts. There aren’t many independent rating agencies evaluating mutual funds around the world. The most influential one in the USA is Morningstar offering the “star rating”. Besides it there are other agencies rating mutual funds like Standard & Poors, Feri, Lipper, Euro Fondsnote and Stiftung Warentest. In concept mutual fund ratings should provide unbiased, new and useful information to market participants to help investors to allocate their assets. Many mutual fund rating agencies show the results in a simplified score. As for Morningstar, it provides stars. Unexperienced investors are used to rely on these condensed ratings, because retail investors cannot scan the wide range of investment opportunities mutual funds are offering. Morningstar states that investors should use the rating only as a starting point and thus not rely only on the star rating.

The final score of the Stewardship rating builds on the following elements:

• General governance structure of the fund

• Linkage between the board and the management

• Proportion of independent board members

• Background of the board members and their independence

• Remuneration and Incentives

• Educational background of managers

Corporate Culture amounts to 40% of the total score and incorporates especially the fiduciary duties. Aspects analyzed show how the fund discloses information and the sustainability of the investment process. Board Quality represents 20% of the score. It shows the alignment of the board with the investors. At least 75% of board members should be independent, which is in line with the requirements of the SEC. A compensation structure, which supports the long-term development is considered to be positive and vice versa.

Ratings mainly based on performance and fund performance itself are the dominant investment criteria when looking at mutual funds. Especially the influence of the star rating becomes apparent when observing the market reactions following changes in Morningstar fund ratings in the USA. The mutual fund flows in the US and United Kingdom (UK) mostly depend on the Morningstar rating and its rating changes., so the ratings in US and UK rely indirectly on past performance. A fund’s past performance is not as important as you might think because past performance does not predict future returns. But past performance shows how volatile or stable a fund has been over a period of time. The more volatile the fund, the higher the investment risk. Past performance is usually non-persistent over longer horizons.

The literature on this rating doesn’t give a clear answer, when answering if this rating in general is able to predict the future performance or the asset turnover. But it’s clear that the board quality and corporate culture seem to be most important. The manager’s incentive component on the other hand is rather less relevant.

However, ratings, as mentioned before, reflect only corporate factors, and inexperienced investors often neglect other factors wich should also be taken into account when making investment decisions. Investors should also pay attention to persistent and easily observable elements that may affect performance. In academic literature, these elements are discussed separately. The factors found show some features which may have advantages or disadvantages for investors. They are for example:

• Fund fees and expenses

• Fund’s affiliation to a bank

• Fund size, asset flows and exit risks

• Structure of management

• Shares of the manager and board member in the fund or fund family.

• The education of general management

Fund fees can be easily observed by the fund’s investors. They represent an outflow of investor’s assets and, in addition, they are associated with a negative impact on performance. Continuous basic fee includes the remuneration for the management, general management costs, trading costs and marketing costs. Some papers and managers argue that high cost is a good sign of skilled managers and that the price is adequate.

However, high fees may be related to an unfavorable for investors corporate structure of the company, as well as inadequately hight managerial fees. Too high fees may suggest that the board is not able to protect the shareholders' interests.

Exit decisions are likely for smaller, younger and weak performing funds and funds charging higher fees. The smallest funds with low inflows are often liquidated due to their current expenses connected to the assets under management, as they are not able to cover the costs. Weak performance is only important in cases of within-family mergers. It’s less probable for mutual funds, which offer a unique portfolio, to be liquidated or sold to other family and within-family mergers occur more often in larger fund families. Therefore, mergers are much more likely between funds with close investment strategies as this decreases the implementation costs.

Mutual funds affiliated to a bank depict a stronger predominance to the conflict of interest, because the fund management is controversial. Although management has fiduciary duties towards the investors in the fund, they are paid by the bank which also works with other businesses. Bank affiliation is considered essential nowadays, as for example in the USA approximately 40% of mutual funds are affiliated to a bank. These funds may have better research resources, lower transaction costs and sometimes more information about the clients of the affiliated bank. This information results from initial public offerings business (IPO), seasoned equity offerings (SEO) business and from the bank’s credit business. Parts of this information is not available for “ordinary” market participants and is thus a private information.

The funds affiliated with an investment bank are assumed to show larger participation rates in SEO and IPO client’s stocks which show higher likelihoods of big abnormal returns in the future in comparison to the market. These specifics should result in better performance in investment bank affiliated mutual funds.

However, in practice mutual funds usually hold such SEO and IPO stocks which sadly perform worse. As result, these mutual funds perform significantly worse than comparable non-investment bank affiliated funds and investors in those funds are adversely affected by the fund’s affiliation to an investment bank. The underperformance is equal to 1% - 1.7% per annum. The recent study finds also evidence that investors in mutual funds affiliated to investments banks suffer in most of the years. In 14 years out of 19 the costs overweighed the benefits of the affiliation to an investment bank. Investment banks generate the vast majority (up to 65%) of their revenues in the investment banking business and below 10% in their mutual fund business.

Credit bank affiliated mutual funds depict increased (decreased) participation rates in those firms which are likely to perform well (worse) in cases where the affiliated credit bank has business contacts. Therefore, these mutual funds present a better performance when comparing to non-credit bank affiliated counterparts. Such effect is due to better information in the financial conglomerates and is most prevalent for younger, smaller and worst performing funds. For this reason, it may be assumed that these companies might use the described actions to stay on the market, so to receive some market shares. In Spain bank affiliated funds usually support the stock of their parent’s bank when they suffer price drops. Mutual fund managers act, especially in the short run, in the interest of the bank and its shareholders, but not in the interest of the investors of the mutual fund, who are adversely affected. In the long run this may have consequences for the bank shareholders, since a worse performing fund might suffer from outflows which also affect the parent bank.

Corporate governance and its influence are debatable among the specialists. Some argue that mutual funds “only” care about the expected return, so qualified governance of the stocks in their portfolio is an afterthought. Other studies state that institutional investors have recognized the importance of a good governance structure of the firm whose stock they buy and increase their holdings in case of good governance. Therefore, better governed firms in general are less likely to be involved in abusive actions or white-collar crime.

First, an option-based payment for board members indirectly represents a holding in the firm, which positively affects the performance because of a more efficient alignment with the shareholders.

Second, a performance-related pay might reduce the incentives of board members to participate in many different boards at the same time. The disadvantage of independent board members having seats in several boards is being more tolerant to the weak performing managers. The mutual fund’s stewardship rating is positively correlated to the corporate quality of the stocks in the mutual fund portfolio. Additionally, those funds with a better stewardship rating dedicate more time in monitoring such companies. Weak governed mutual funds (inferior stewardship rating) usually vote in the favor of the management the fund is invested in. Active monitoring and participation in proxy votes is costly. Therefore, the specialists mostly assume that mutual funds don’t take part in such actions and rather vote with their feet and sell their shares when they discover corporate wrongdoing.

The overall stewardship grade and the portfolio turnover are constantly negative correlated. The correlation becomes stronger and is significant until the 80th quantile, afterwards the correlation effect decreases and is insignificant at the 90th quantile. The board quality and corporate culture are most important components. The difference in alpha from well to badly governed mutual funds amounts each 1 to 1.5% annually, whereas the manager’s incentives have only marginal impact or precisely in some quantiles. Good corporate culture usually means stable and more reliable outcome. This is beneficial for the investors and company (the mutual fund) as whole. A less volatile performance offers less incentives to managers to increase risk in the purpose of recovering (potential) losses.

Statistics depict that well governed funds outperform those worse governed by up to 1.5% a year. The result is also affected by a great underperformance of the poorly governed mutual funds.

A good corporate culture incorporates mainly three distinct elements:

1. A consensus of norms and behavior rules facilitates the detections of corporate wrongdoing and also prevent corporate wrongdoing.

2. “Goal alignment” decreases the uncertainty in decision making and lowers complicated debates.

3. Enhanced motivation and effort, because employees feel that their actions are really valuable and that they are more independent.

The manager’s incentive component isn’t as impactful. It isn’t surprising as the two components: managerial holdings and the compensation structure included in manager incentives usually show reverse effects on the behavior of mutual fund

It is possible for mutual funds to outperform their benchmark if the holdings differ from the benchmark. The deviation to the benchmark either originates by factor timing and/or stock picking ability.

As for stock picking ability, it’s presented by chosen single stocks. Therefore, we can assume that those funds, which extensively pick stocks are also those funds whose managers have good networks and thus predominately pick stocks.

The active share and the tracking error are defined by the deviation to the benchmark index. The tracking error is calculated this way:

The tracking error isn’t affected by selective stock picking, but the factor timing has an impact on the tracking error. Consequently, the tracking error is not able to identify a stock picker. Still, the tracking error can be used to identify a factor timer. The active share can be defined as:

where w_fund,i and w_index,i are the weights of the asset i in the fund portfolio and in the benchmark index. The overweight in the fund relative to the index means an active long position. And that’s why smaller or no holdings of a single stock relative to the benchmark mean active short position. The article states that combining the tracking error as the common measure of the activeness of a portfolio and the active share result in a good estimate about the source of the mutual funds success.

According to the findings, mutual funds that have a change in their risk exposure and in their active share usually perform less efficient. The highest active share mutual funds surpass the benchmark before fees by 1.5% to 2.4% per annum, which suggest stock picking skill. The funds with the lowest active share make a return of 0.1 to –0.6% relative to the benchmark. Statistics depict that mutual funds, which are in the two highest active share quintiles, surpass the lowest active share quintiles by 1 to 2 percent per annum.

Additionally, smaller funds are in general more active in comparison to larger ones. The active share of mutual funds is most of the time approximately 70% until the fund has a volume of $1 billion. Afterwards the active share decreases to 60% until the fund volume has a volume of $10 billion and as result the active share decreases to 50%. More investment opportunities than larger mutual funds and less liquidity constrains is a characteristic of smaller funds.

The next step is to rank mutual funds in accordance with their performance in regard to their exposure to active share and tracking error. The mutual funds which perform the greatest are “concentrated stock picks”, which have at the same time a high active share and high tracking error. After that there are “diversified stock pickers” with a high active share and low tracking error. The mutual funds, which are close to the benchmark index with a low active share and a low tracking error, tend to perform inefficient as well. Funds with a low active share and a high tracking error, betting only on factors are the worst.

Conclusions

To conclude, this study analyzed which criteria are to be used by investors when selecting mutual funds. The mutual fund investors pay biggest attention to the past performance, which means that investors seem to underestimate other significant factors. These are for example the costs associated with mutual funds, governance issues or the active share of mutual funds. The underestimation of expenses and load fees is interesting, because these costs have a direct negative impact on investors’ return. Governance criteria in the selection of mutual funds especially by retail investors turn out to have little impact, which shows misunderstanding of the importance of governance criteria. However, recent scandals will increase the awareness of these criteria even for retail investors.

In Europe the vast majority of mutual funds are distributed via banks, hence those funds with linkages to banks show a much weaker performance flow compared to those not affiliated to banks. Another fact is that those mutual funds in Europe are also often more expensive than mutual funds not linked to banks.

The above stated patterns suggest that some investors do not understand the basic functionalities of mutual funds and just follow the advice of their bankers. Moreover, especially regarding the sources of superior performance, there is much research to be done. This is due to the reason that the literature usually captures “only” one small aspect without incorporating other aspects.

Научный руководитель:
Смирнов Валерий Валерьевич
Россия, г. Москва
Мамасаидова Муаззам Икромжон Кизи
студент, Финансового университета при Правительстве РФ
Россия, г. Москва
Хомяков Артём Сергеевич
студент, Финансового университета при Правительстве РФ
Россия, г. Москва
Овчинникова Екатерина Александровна
студент, Финансового университета при Правительстве РФ
Россия, г. Москва

CRITERIA FOR INVESTING IN INTERNATIONAL MUTUAL FUNDS

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