Two Essays on the Mutual Fund Industry

Abstract

This thesis consists of two essays on the mutual fund industry using a sample of equity mutual funds in the Korean market from July 2001 to December 2009. The first essay explores the relationship between fund size and fund performance in the Korean market, where there exist many small funds. When a market is crowded with many small funds, a fund manager is likely to manage more than one fund. We argue that a kind of agency problem emerges in this situation: fund managers tend to neglect very small funds by simply holding cash rather than investing because of their limited time and efforts in managing many funds simultaneously. We investigate the Korean fund market as a case: about half of the entire funds are very small funds whose sizes are below 5 billion Korean won (less than five million U.S. dollars), and one fund manager simultaneously manages about 10 funds on average. We find that small funds perform worse than large funds: the difference in returns between the largest and smallest fund size quintile is more than 3% per year. We use the cash holding ratio as a proxy for the managers negligence. We find that cash holding ratio monotonically decreases with fund size. As our negligence hypothesis predicts, fund size is indeed unrelated to fund performance after being controlled for the cash holding ratio. The second essay tests the controversial argument that the mutual fund industry makes excessive profit from fund investors through sales expenses (12b-1 fees in the United States), which has attracted the attention of the media, practitioners, and the financial regulatory authorities. Unlike previous studies that treat mutual fund expenses as a whole, we separately identify management expenses and sales expenses using Korean data. We find that high management expense funds outperform low management expense funds in terms of gross returns. In addition, their outperformance sufficiently offsets their higher expense. In contrast, we find no evidence that higher sales expenses are related to better performance. We also find a significant negative relation between sales expenses and fund flows but fail to find such a relation between management expenses and flows. We also show that aggregate active mutual funds can outperform aggregate passive mutual funds when excessive sales expenses are eliminated, although active investing per se is a negative-sum game in the sense of equilibrium accounting.