Most of the focus of the literature on active mutual funds has been on the question about their performance and the related issue about whether or not active fund managers have skill. On the other hand, the composition and characteristics of mutual fund portfolios have largely been ignored.
Martin Lettau, Sydney Ludvigson and Paulo Manoel contribute to the literature with their December 2018 study “Characteristics of Mutual Fund Portfolios: Where Are the Value Funds?”, which provides a comprehensive analysis of portfolios of active mutual funds, ETFs and hedge funds through the lens of risk (anomaly) factors such as size, value and momentum.
Among the questions they try to answer are: “To what extent do active fund managers exploit these factor premia? If there are limits to arbitrage, do active funds contribute to the existence of these anomalies or do they overweight underpriced stocks? And, more broadly, what set of strategies is available to retail investors via active funds?”
Their analysis focused primarily on holdings of mutual funds (versus regressions of fund returns). Their data sample covers the period 1980 through June 2016 and includes 2,638 funds (574 “value” funds, 1,130 “growth” funds, 955 ETFs and 114 hedge funds).
Following is a summary of their findings:
- Funds do not systematically tilt their portfolios toward profitable factors, such as high book-to-market (BtM) ratios, high momentum, small size, high profitability and low investment growth. In fact, for some factors, mutual funds target the low-return leg of long/short factor portfolios rather than the high-return leg. This bias is especially strong for BtM ratios.
- There are virtually no high BtM funds in the sample, while there are many low BtM “growth” funds. For example, only seven out of 2,657 funds in their sample have a BtM score in the fourth quintile or above (while 18% of S&P 500 stocks have a BtM score above 4). The bulk of “value” funds (mutual funds, ETFs and hedge funds) have BtM scores between 2 and 3.5. Further, value funds hold a larger portion of their portfolio in stocks in the lowest BtM quintile (24%) than in stocks in the highest BtM quintile (13%).
- Portfolios of “growth” funds are concentrated in low BtM stocks, but “value” funds hold stocks across the entire BtM spectrum—more than half of all value funds hold a larger share of low BtM stocks than high BtM stocks, and only 7% hold more than 25% of their portfolio in high BtM stocks.
- Even funds with an explicit value objective hold a larger share of low BtM stocks than high BtM stocks in their portfolios. This bias is present in other value/growth measures, such as the earnings-to-price and dividend-to-price ratios.
- While there are some micro/small/midcap funds, the vast majority of mutual funds holds very large stocks.
- The fund-level distributions of other factor characteristics (momentum, proﬁtability and investment growth) also exhibit little variation across funds—the distributions of other characteristics are more symmetric and clustered around scores of 3. For example, the mean mutual fund has a momentum score of 3.28, a proﬁtability score of 3.17 and an investment score of 3.08, and few funds have scores below 2 and above 4. This suggests funds do not systematically target these characteristics.
- The characteristics distributions of ETFs and hedge funds do not differ significantly from those of mutual funds.
Lettau, Ludvigson and Manoel concluded: “Our results suggest that active mutual funds do not systematically hold the stocks with characteristics associated with high returns and thus are unlikely to contribute to any shrinking of factor premia during the sample period.”
They did caution that, while their sample of mutual funds and ETFs was exhaustive, they only observed portfolio holdings of a very small subset of small hedge funds. Thus, they could not rule out that (larger) hedge funds tilt their portfolios toward proﬁtable characteristics.
The authors’ findings have important implications for investors: You cannot rely on a fund’s name or even its stated objective when seeking exposure to factor characteristics. You have to take a deeper dive and look into the fund’s actual holdings.
It was interesting to note that, of the 10 funds with the highest BtM score, three were from Dimensional Fund Advisors (their U.S. small value, targeted value and large value funds), and a fourth was a fund for which they are the subadvisor, a large value fund (scores between 4.0 and 4.1). Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.
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