Morningstar Advisor - Fall 2007 - (Page 18)

Gray Matters What is the meaning of serial correlation in mutual funds, whose portfolios generally contain liquid securities? Could a relatively high serial correlation imply that a mutual fund has a higher consistency of returns, which many would regard as a desirable feature? If Morningstar has done any studies of serial correlation in mutual funds, what were the results and what sort of distribution of correlations did you find, especially among different fund categories? To set the stage for answering the first two questions, I’ll begin by answering the third. To do this, I searched Morningstar’s U.S. open-end mutual fund database for funds that have at least 60 months of return data ending in August 2007. Limiting the search to no more than one share class per portfolio, I obtained data on 4,821 distinct funds, representing all 68 Morningstar categories. I estimated their one-month serial correlation just as I did for the hedge fund article. In contrast to the hedge fund data, I found very few mutual funds that exhibit significant levels of serial correlation. Only 155 out of the 4,821 funds have a serial correlation coefficient of at least 25% and only 87 have one of at least 30%. Based on this, we conclude that only 2% to 3% of distinct mutual funds exhibit serial correlation of returns. The categories in the table are ones that contain at least one distinct fund with a serial correlation coefficient of at least 25%. I also list the number of distinct funds within the category, the number of those that have a serial correlation coefficient of at least 30%, and the number that have a serial correlation coefficient of least 25%. The categories are sorted by the fraction of funds within the category that have a coefficient of at least 25%, meaning that the categories whose funds are most prone to serial correlation are at the top of list. Of the 68 mutual fund categories, only 30 make the list. The categories of funds that invest primarily in most liquid of long-term securities, large-cap stocks, are not on the list, because none of the funds in these categories have significant serial correlation. At the top of the list are those categories of funds that invest primarily in either less-liquid or short-term securities. The remainder of the list shows a smattering of funds across a number of categories, indicating that the funds in these categories generally do not exhibit serial correlation. For the few funds that do exhibit serial correlation in these categories, the result is likely to be spurious. For example, for the sole moderate allocation fund that has a serial correlation coefficient over 25%, the largest monthly return was followed by another large return the following month. Removing this single observation causes the estimated level of serial correlation to fall to about 15%. With this information, I can now answer our reader’s first two questions. First, he asks what is the meaning of serial correlation in mutual funds, whose portfolios generally contain liquid securities? The answer is that mutual funds that contain long-term liquid securities rarely exhibit serial correlation, and when they do, it is likely to be spurious. By the way, the same is true of hedge funds. The reason that the results are so different for hedge funds is that a far greater proportion of hedge funds hold illiquid or hard-to-price securities than do mutual funds. The reason that a portfolio of long-term liquid securities does not exhibit serial correlation is that the markets for these securities are information-efficient, at least in the weakest sense. The notion of market efficiency is a subject of much controversy, but there is less disagreement among academics and investment practitioners that percentage price changes from the past can systemically be used to predict percentage price changes in the future. The reason is that if price changes were so easily predictable, market participants would act so rapidly on these predications that prices would move before nearly anybody could have a chance to make a profit. Where There’s Serial Correlation The categories in which serial correlation occurs contain mutual funds that invest in less-liquid or short-term securities. Category No. of Distinct Funds Funds With Funds With Serial Serial Correlation Correlation . . 25% 2 30% 2 Multisector Bond Foreign Small/Mid Value Ultrashort Bond Bank Loan Foreign Small/Mid Growth High Yield Bond Europe Stock Diversified Pacific/Asia Pacific/Asia ex-Japan Stk Convertibles Emerging Markets Bond Japan Stock Specialty-Health Long-Short Specialty-Real Estate Small Value Conservative Allocation Muni National Short Small Blend Short-Term Bond Specialty-Financial World Stock World Bond Foreign Large Value Foreign Large Blend Small Growth Mid-Cap Growth Mid-Cap Blend Intermediate-Term Bond Moderate Allocation 34 22 39 18 22 115 29 7 28 19 17 17 52 19 65 92 77 32 161 106 38 98 53 61 159 195 228 131 287 222 16 10 19 5 2 15 4 0 2 0 0 0 1 0 2 1 0 1 0 2 0 1 0 0 1 1 2 1 1 0 25 13 22 8 8 28 5 1 3 2 1 1 3 1 3 4 3 1 5 3 1 2 1 1 2 2 2 1 2 1 18 Morningstar Advisor Fall 2007

Table of Contents Feed for the Digital Edition of Morningstar Advisor - Fall 2007

Morningstar Advisor Fall 2007 Features Departments Letter from the Editor Inbox 10 Years After: Developing Markets Make Progress Research Briefs Investors Should Adjust Their Home Bias Few Mutual Funds Exhibit Serial Correlation Valuating ETFs, the Equity Analyst's Way It’s All About Location See the World (Differently) The Return of the Global Flexible Investor Map of International Value Sound as a Loonie? Fair Exchange In Their Own Worlds A Good Read Putting Their Heads Together Buying Protection Scoping Out Easy-to-Use Funds Finding Good Stewards Consumer Firms Go Global Mutual Fund Analyst Picks Undervalued Stocks Most Popular Variable Annuities New at Morningstar The Whole Wide World

Morningstar Advisor - Fall 2007

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