Mutual funds are managed pools of financial assets that can be invested in by retail or institutional investors. Funds can be classified into sectors on the basis of the securities they invest in. These sectors then become a natural peer group within which funds compete and against whom external bodies typically assess performance.
Knowing whether there is persistence in mutual fund performance is of concern both to investors and to fund managers. The existence of performance persistence tells us whether fund managers add value and whether past fund performance information should be taken into account by investors when making their investment decisions.
The literature on performance persistence is extensive. One question that has not been asked to date is whether past performance information is equally useful for predicting fund performance across different sectors. Knowing whether this is the case could be of interest to those on both the demand and supply side of the fund management industry. We would expect some investors to use such information to focus their investments in sectors where past returns are more useful in predicting performance. On the supply side, fund families might choose to open new funds in sectors where they have a greater chance to do persistently better than other funds (or shun such sectors for fear of doing persistently worse).
In order to answer the question of whether performance persistence differs between sectors we use data from the UK open ended managed funds (unit trust) industry. The advantage of working with UK data is that in the UK there is a dominant system for classifying funds into sectors. This is determined and enforced by the Investment Management Association (IMA). This means that there exists a consensus about a given fund’s set of competitors. This allows us to test for cross sector differences in persistence cleanly.
Whether there is persistence in the UK open-ended managed funds industry has been discussed by practitioners and academics in a recent lively debate. Papers that have contributed to this debate include Blake and Timmermann (1998, 2003), Rhodes (2000), Quigley and Sinquefield (2000), Fletcher and Forbes (2002), and Giles et al. (2002a,2002b). Interestingly the fund industry regulator in the UK considered at one point banning fund advertisements containing past performance information (Financial Services Authority, 2001). All existing studies of UK performance persistence to date have focused on sectors where funds invest primarily in UK equities. By examining sectors where funds are not restricted to UK equities we are able to test whether existing results concerning performance persistence carry over from the UK equities sectors to other sectors as well (over our sample period the asset share of these sectors grew from 40% to 52% of the unit trust industry).
Looking at performance persistence across different fund sectors also allows us to test what determines persistence differences between sectors. Recent work by Berk and Green (2002) has highlighted the role of competition in eliminating persistence in returns. If this is the case we would expect to see a link between levels of sector persistence and characteristics that measure sector competitiveness. We test whether variables that proxy for the competitiveness of a sector are able to explain differential persistence.