Partial Adjustment Toward Equilibrium Mutual Fund Allocations: Evidence from U.S.-based Equity Mutual Funds

Mutual fund managers face increasing competition and have incentives to quickly reallocate their portfolios in order to achieve the best risk-adjusted return. However, portfolio allocation is costly, as trading, administrative, and information costs all lower returns after management fees. Therefore, the mutual fund manager’s portfolio allocation decision is one of a tradeoff between the benefits of quick portfolio adjustment and the associated costs of adjustment. We apply an asymmetric partial adjustment model to a sample of U.S. equity mutual funds from 2000 through 2012. Empirical results shows that mutual fund managers are able and willing to quickly adjust portfolios when the fund underperforms, offsetting nearly 95 percent of the deviation within one month, indicating that managers perceive the costs of retaining sub-optimal portfolios to be high, relative to the costs of rebalancing. The results are consistent across different types of equity funds. As a secondary result, we show that the speed of adjustment is fairly stable over the 2000 to 2012 sample period, but does exhibit some cyclicality. The application of the partial adjustment model methodology to the mutual fund literature is novel and contributes significantly to the current literature. In addition, the preliminary results have important implications as to the efficiency of mutual funds, which has been questioned in recent years and is relevant to mutual fund investors, managers, and governors.