Conclusion

This paper provides an empirical analysis of the effect of investor externality on

open-end mutual funds included in U.S. 401(k) retirement pension plans. We test two

hypotheses to verify our concerns. First, investor externality is stronger in retail

oriented funds than in institution oriented funds. We expect that the redemption

pattern in retail investors has devastating effect on fund performance in terms of

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lower buy-and-hold abnormal return and this negative effect will hurt the participants

who are long-term investors in 401(k) pension plans. Using the 401(k) mutual funds

data, we find strong support.

Second, we hypothesize that the funds with high past investor externality will

have higher investor externality, which will hurt the long-term investors in 401(k)

pension plans in terms of lower buy-and-hold abnormal return. We use net outflow at

least 5% of its total net asset value as our dummy for large outflows. Such outflows

force the fund manager to deviate from their desired optimal fund portfolio and

engage in uninformed, liquidity-motivated trading that is costly and unprofitable.

Using the performance-outflow regression documented by Chen, Goldstein, and Jiang

(2010), we can distinguish funds with high past investor externality from funds with

low past investor externality. The empirical results also support our argument. In our

final subsample funds with high past investor externality, we find that these funds

include small-cap, mid-cap funds and emerging market funds (with small sample size)

which are defined as “illiquid funds” by Chen, Goldstein, Jiang (2010). In general,

our empirical analysis provides evidence regarding the negative effect of investor

externality in retail oriented funds and those funds inherently suffer more outflows.

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Table 1 : Variable definitions and summary statistics

The sample contains 294268 fund-share-month observations from 1719 401(k) fund-shares mostly over 1991-2011. Data items are collected from FORM 11-K and the Center for Research in Security Prices (CRSP) mutual fund database. Size is the total net assets as of month-end. The expense ratio, which is reported as a percentage of fund assets, includes fund operating expenses and 12b-1 fee.Turnover ratio is the minimum (of aggregated sales or aggregated purchases of securities), divided by the average 12-month total net assets of the fund. Annual return is the simple arithmetic return of the fund-share. The indicated variable is first averaged across all observations for a particular fund. Statistics are then presented on these 1693 mean values.

Mean Std. deviation Median

Size ($millions) 1882.76 6078.6 279.9

Expense 1% 0.50% 1%

Number of monthly obs. 171.18 59.5 174

Number of monthly outflow frequency 83.35 42.48 81

Outflow -7% 90% -2%

Annual return 0.60% 5% 0.60%

turnover ratio 99% 149% 66%

Table 2 : Panel A. Investor Externality : retail funds in 401(k) plans V.S. institutional funds in 401(k) plans

The 1719 fund-shares in 401(k) plans are classified into retail class funds and institutional class funds and there are 303 retail-oriented funds and 263 institutional-oriented fund-shares in panel A. Size is the total net assets as of month-end. The expense ratio, which is reported as a percentage of fund assets, includes fund operating expenses and 12b-1 fee.Turnover ratio is the minimum (of aggregated sales or aggregated purchases of securities), divided by the average 12-month total net assets of the fund. Annual return is the simple arithmetic return of the fund-share. The indicated variable is first averaged across all observations for a particular fund. Statistics are then presented on these 303 mean values and 263 mean values from 1991-2011 respectively. Observations are at the fund-share-month level.

Retail-oriented funds (High investor externality funds) Institutional-oriented funds (Low investor externality funds)

Mean Standard Deviation Median Mean Standard Deviation Median

Size ($millions) 1788.92 5730.03 292.31 Size ($millions) 977.43 4757.66 153.6

Expense 1% 0.50% 1% Expense 0.80% 0.40% 0.80%

Number of monthly obs. 181.04 54.81 183 Number of monthly obs. 163.43 52.95 172

Number of monthly outflow frequency 95.03 44.60 91 Number of monthly outflow frequency 77.25 38.75 76

Outflow -16% 201% -2% Outflow -8% 72% -3%

Annual return 0.60% 5% 0.70% Annual return 0.60% 5% 0.60%

turnover ratio 118% 242% 72% turnover ratio 97% 101% 74%

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Table 2 (continued) : Panel B. Investor Externality : funds with high past investor externality V.S. funds with low past investor externality

By using equation 1, we have final subsample containing 80 high investor externality and 34 low investor externality fund-shares in panel B.

Size is the total net assets as of month-end. The expense ratio, which is reported as a percentage of fund assets, includes fund operating expenses and 12b-1 fee.Annual return is the simple arithmetic return of the fund-share. Turnover ratio is the minimum (of aggregated sales or aggregated purchases of securities), divided by the average 12-month total net assets of the fund. The indicated variable is first averaged across all observations for a particular fund. Statistics are then presented on these 80 mean values and 34 mean values from 1991-2011 respectively.

Observations are at the fund-share-month level.

High investor Externality funds Low investor externality funds

Mean Standard Deviation Median Mean Standard Deviation Median

Size ($millions) 1732.44 4288.69 202.35 Size ($millions) 918.93 2324.66 288.37

Expense 1% 0.60% 1% Expense 1% 0.40% 0.90%

Number of monthly obs. 181.22 49.25 185.5 Number of monthly obs. 165.76 49.83 160.00

Number of monthly outflow frequency 89.71 37.37 87.50 Number of monthly outflow frequency 79.08 37.81 71

Outflow -3% 2% -3% Outflow -5% 7% -3%

Annual return 0.60% 4% 0.70% Annual return 0.60% 6% 0.70%

turnover ratio 79% 97% 57% turnover ratio 119% 268% 57%

Table 3 : Pooled regression of all funds in 401(k) plans

The dependent variable is Performancei,t in month t. Outflowi,t-1 is a dummy variable equals to one if the fund experiences net outflow of at least 5% of its total net asset value in month t-1, and zero otherwise. Size is the total net assets as of month-end. The expense ratio, which is reported as a percentage of fund assets, includes fund operating expenses and 12b-1 fee. Ret(-i) is the one factor alpha during the i-th month prior to month t. Observations are at the fund-month level. * and **

indicate statistical significant at less than the 10% and 5% level, respectively.

Dependent variable: Performance_i,t

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Table 4 : Effects of Investor Externality on 401(k) mutual fund –retail funds in 401(k) plans V.S. institutional funds in 401(k) plans By our definition, retail class fund represents funds with high investor externality, and institutional class fund represents funds with low investor externality. Of the 1719 401(k) fund shares, after matching their “mate” mutual funds which have the same fund name but with different shares, there are 303 retail-oriented funds and 263 institutional-oriented funds left from 1991-2011. BHARi is calculated as ∏

∏ representing the performance of retail fund i with high investor externality in 401(k) plans after controlling the manager ability represented by its mate fund. BHARj is calculated as ∏ ∏ representing the performance of institutional fund j with low investor externality in 401(k) plans after controlling the manager ability represented by its mate fund. Observations are at the fund-share-month level. *** indicate statistical significant at less than the 1% level.

Variable N Mean SD t t-test for equality of means 95% confidence level

Sig. (2-tailed) Mean difference S.E. difference Lower Upper BHARi High IE 605 0.1006 0.2546

-4.29 <.0001^*** -0.0708 0.0165 0.0803 0.1210

BHAR_j Low IE 610 0.1714 0.3170 0.1462 0.1966

Table 5 : Effects of Investor Externality on 401(k) mutual fund- funds with high past investor externality V.S. funds with low past investor externality

Of all 1719 401(k) mutual funds Estimated by Eq. (4), we have subsamples of 171 high investor externality and 123 low investor externality fund-shares respectively. After matching their “mate” mutual funds which have the same fund name but with different shares, we have 80 high investor externality and 34 low investor externality fund-shares from 2006-2011. BHARi is calculated as ∏ ∏ representing the performance of funds with high past investor externality fund i after controlling the manager ability represented by its mate fund. BHARj is calculated as ∏ ∏ representing the performance of funds with low past investor externality j after controlling the manager ability represented by its mate fund. Observations are at the fund-share-month level. **indicate statistical significant at less than the 5% level.

Variable N Mean SD t t-test for equality of means 95% confidence level

Sig. (2-tailed) Mean difference S.E. difference Lower Upper

BHAR_i High IE 270 0.0088 0.0817

-2.46 0.0143** -0.0138 0.0075 -0.0009 0.0186

BHARj Low IE 126 0.0227 0.0296 0.0175 0.0279