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Investor Heterogeneity and the Cross-section of U.K. Investment Trust Performance

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Abstract

We use the upper and lower bounds derived by Ferson and Lin (2010) to examine the impact of investor heterogeneity on the performance of U.K. investment trusts relative to alternative linear factor models. We find using the upper bounds that investor heterogeneity has an important impact for nearly all investment trusts. The upper bounds are large in economic terms and significantly different from zero. We find no evidence of any trusts where all investors agree on the sign of performance beyond what we expect by chance. Using the lower bound, we find that trusts with a larger disagreement about trust performance have a weaker relation between the trust premium and past Net Asset Value (NAV) performance.

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Notes

  1. See Chen and Knez(1996) for an overview of evaluating fund performance using the stochastic discount factor approach.

  2. The issue of investor heterogeneity on fund performance is also explored implicitly in the papers by Chen and Knez(1996) and Ahn, Cao and Chretien(2009).

  3. Investment trusts are equivalent to closed-end U.S. mutual funds.

  4. Aragon and Ferson(2008) provide an excellent overview of different fund performance measures and provide a survey of managed fund performance. Ferson(2010,2012) provides a review of the fund performance literature and shows how the stochastic discount factor approach can be used to unify a number of important issues in fund performance.

  5. See Ferson and Lin(2010) for full details as to the derivation of their bounds.

  6. This analysis is linked to the good deal option pricing bounds of Cochrane and Saa-Requejo(2000).

  7. Ferson and Siegel(2003) derive their adjusted Sharpe ratio under multivariate normality.

  8. We also correct the average conditional maximum Sharpe ratio using the adjustment in Ferson and Siegel(2003) when N > 1.

  9. Full details of the bootstrap approach is included in an appendix, which is available on request. We also use the bootstrap approach to simulate the cross-sectional distribution of trust performance when there is zero performance.

  10. We are grateful to the reviewer suggesting that we explore this issue.

  11. Ahn et al.(2009) extend the work of Chen and Knez(1996) by deriving the performance bounds of a fund implied by a set of NA admissible stochastic discount factors. They interpret the upper (lower) performance bound as the performance value of the fund from the perspective of the investor clientele most (least) favorable to the fund. Fletcher and Marshall(2012) use the NA performance bounds of Ahn et al.(2009) to evaluate the performance of U.K. investment trusts.

  12. The investment sectors have changed names over the years. The four sectors are the current names of the U.K. investment sectors as at the end of the sample period. In the early part of the sample period, there was a U.K. General sector. We allocate trusts in the U.K. General sector to the U.K. Growth sector since most trusts transferred to this sector when the classifications changed.

  13. See Dimson and Minio-Paluello(2002) for a review of the alternative explanations of the closed-end fund discount. Recent studies by Berk and Stanton(2007) and Cherkes, Sagi and Stanton(queryCherkes et al. 2009) develop theories of the fund premium in relation to expectations about future managerial performance ability or to the liquidity benefits provided by the funds. Ramadorai(2012) provides support for these theories in explaining the closed hedge fund premium.

  14. The motivation for including these information variables stems from the large literature on predictable stock returns. See Lettau and Ludvigson(2010) for an excellent review of this literature.

  15. We use the t(ap) statistic, rather than ap, since it corrects for differences in standard errors across trusts due to different residual volatilities, and a different number of return observations (see Fama and French(2010)).

  16. The lack of funds with significant positive alphas might be due to the reverse survivorship bias of Linnainmaa(2012).

  17. In unreported tests (available on request), we estimate the upper bounds using the NAV excess returns of the trusts. We find similar results to Table 4 except the magnitude of the bounds is lower.

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Authors and Affiliations

  1. Department of Accounting and Finance, University of Strathclyde, Curran Building, 100 Cathedral Street, Glasgow, G4 0LN, UK

    Jonathan Fletcher & Andrew Marshall

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  1. Jonathan Fletcher
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  2. Andrew Marshall
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Correspondence to Andrew Marshall.

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Helpful comments received from an anonymous reviewer.

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Fletcher, J., Marshall, A. Investor Heterogeneity and the Cross-section of U.K. Investment Trust Performance. J Financ Serv Res 45, 67–89 (2014). https://doi.org/10.1007/s10693-013-0159-1

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