Mutual Fund Portfolios

Most workers invest money from their monthly paychecks into a pension fund. Major tax benefits of tax deductions and tax shields encourage people to save money through their pension fund investments. The money invested in pension funds is typically placed with different mutual funds. For example, an employer could allow employees to invest in mutual funds offered by Fidelity Investments, Vanguard Asset Management, iShares, USB Group, State Street Global Advisors, Morgan Stanley, JP Morgan Chase, Allianz Group, Capital Group, Goldman Sachs, BlackRock, American Funds, etc. Also, non-pension investors can buy mutual funds but do not receive the tax benefits of pension accounts. As of this writing, there are over 7,000 mutual funds managing over $28 trillion in investment funds in the U.S. Open-end funds make available unit shares of ownership on demand. Closed-end funds have a limited number of outstanding unit shares that can be bought in the market. Mutual funds offer a wide variety of long only portfolios to investors, including equity, money market funds, bonds, real estate, commodities, target date funds, etc. In this chapter, we will focus on equity mutual funds, which are popular among long-run pension investors. A major problem facing employees and others that invest in mutual funds is: How do I choose from the thousands of available funds? This problem harkens back to Markowitz (Journal of Finance 7:77-91, 1952; Portfolio selection: Efficient diversification of investments, Wiley, New York, 1959), who proposed that investors should choose portfolios with the highest return per unit total risk on the efficient frontier. Mutual funds are essentially portfolios that lie somewhere within the mean-variance parabola. In the context of the ZCAPM by Kolari et al. (A new model of capital asset prices: Theory and evidence. Palgrave Macmillan, Cham, Switzerland, 2021), they all have beta risk and zeta risk characteristics that determine their location within the parabola. Thus, we can apply our ZCAPM-based investment methods to assess the return and risk performance of mutual funds. Historical evidence has shown that passive general stock market indexes like the S&P 500 index outperform over 90% of professional money managers over longer periods of time beyond three to five years. Due to these well-known performance results, many mutual fund investors select passive market indexes with relatively low management costs compared to actively managed funds. In previous chapters, we showed that general stock market indexes, such as the CRSP market index, lie approximately on the axis of symmetry in the middle of Markowitz’s mean-variance parabola. As demonstrated in Chapters 8 and 9 , net long portfolios based on the G portfolios and long-short portfolios with different levels of ZCAPM zeta risk well outperformed the CRSP index. Chapter 10 applied ZCAPM investment methods to the construction of long only stock portfolios. Again zeta risk sorted portfolios well outperformed the CRSP index. Much more efficient portfolios can be constructed using individual stocks in optimally weighted net long portfolios. Can the ZCAPM be applied to mutual fund investments in the same way as individual stocks in earlier chapters? That is, can mutual funds be combined into portfolios based on beta and zeta risk in the ZCAPM boost performance relative to general stock market indexes? In this chapter, we apply the ZCAPM to mutual fund investments. Only mutual funds specializing in publicly traded equities that are actively managed are selected (i.e., no passive equity funds). Mutual funds are formed into portfolios containing 10 funds. The mutual funds are rebalanced monthly over the analysis period from January 2000 to June 2022. Out-of-sample returns are computed in the next month to be consistent with real work investor behavior. Mutual funds are sorted into portfolios with different levels of beta risk and zeta risk. Do average returns of mutual fund portfolios increase as beta risk and zeta risk increase? How do their return and risk profiles compare to the CRSP market index? To the minimum variance portfolio G that we developed in Chapter 7 ? Can the ZCAPM help investors to boost their mutual fund returns? These and other questions are addressed here. In the next section, we overview our empirical methods. The following section presents our findings for U.S. mutual funds. The last section gives a summary.