The Effects of Fund Commonality in Mutual Fund Families on Fund Operating Expenses and Return Correlations: Evidence from U.S. Equity Mutual Funds

(ProQuest: ... denotes formulae omitted.)1. IntroductionMany people in the United States use mutual funds as investment and retirement saving vehicles. Over 90 million individual investors owned mutual funds and held about 87% of the total mutual fund assets in 2014 (Investment Company Institute [ICI], 2015). Mutual fund investors often limit their transactions to one fund family to save search costs (Ciccotello, Miles, and Walsh, 2007; Sirri and Tufano, 1998), to simplify fund management (Elton, Gruber, and Green, 2007), or as a result of following a fund family's reputation (Ciccotello, Greene, and Walsh, 2007; Gerken, Starks, and Yates, 2014). In addition, mutual fund investors have become sensitive to a fund's expense ratio.1 Fig. 1 shows the simple average expense ratios, the asset-weighted average expense ratios, and the difference between the two expense ratios of equity funds for the period of 1996 to 2014 (ICI, 2015). The figure indicates that even if the mutual fund industry has recently provided more low-cost equity funds, equity fund investors have kept their sensitivity to fund expense ratios. Because long-term returns are significantly affected by fund expenses (e.g., Carhart, 1997; Gil-Bazo and Ruiz-Verdu, 2009; Haslem, Baker, and Smith, 2008), it is natural that fund investors focus on a fund's expense ratio. However, if a lower expense ratio results from increased fund commonality within a family, seeking only low-cost funds from one family may result in increasing an investor's portfolio risk.In this study, we measure the commonality of funds by how much a fund holds the same stocks for other funds in the same family and whether a fund is managed by multi-fund managers who simultaneously manage multiple funds in the family. Common stock holdings and multi-fund management have been recognized in the recent literature that emphasizes mutual funds as members of a fund family rather than as stand-alone entities (e.g., Agarwal, Ma, and Mullally, 2015; Choi, Kahraman, and Mukherjee, 2013; Elton et al., 2007; Yadav, 2010). Common stock holdings and multi-fund management may reduce fund operating expenses (excluding 12b-1 fee), which are associated with portfolio management and administrative services. The two fund commonalities, however, may also enhance return correlations between funds and thereby increase an investor's portfolio risk.This study examines the effects of common stock holdings and multi-fund management of funds on fund operating expenses and return correlations. Common stock holdings and multi-fund management are assessed only for pairs of funds that have different investment objectives, by excluding pairs of funds that have the same investment objective. Because of this exclusion, the fund commonalities are conservatively evaluated. We analyze 154 actively managed U.S. equity funds from 46 fund families for the period of 2001 to 2006, reconciling key data items (such as a fund's stock holdings and managers) in the Center for Research in Security Prices (CRSP), the Thomson Financial Mutual Fund Holdings, and the Morningstar databases. We find that common stock holdings and multi-fund management are negatively related to fund operating expenses but positively related to the correlation of fund return residuals, which increases the correlation of fund returns. For a portfolio that is constructed with funds in the same family, the findings indicate that an increase in a portfolio's risk-adjusted return net of expenses (such as a Sharpe ratio using expenseadjusted returns) because of decreased fund operating expenses can be wiped out by an increase in the portfolio risk because of increased return correlations. Because of the opposite effects on a portfolio's risk-adjusted return, we additionally investigate the effects of the fund commonalities on risk-adjusted returns of a portfolio that consists of equity funds with different investment objectives and find that the fund commonalities can have negative net effects on risk-adjusted returns of the portfolio. …