Title

The impact of the short-short rule repeal on timing ability and other characteristics of mutual funds

Date of Award

2003

Degree Type

Dissertation

Degree Name

Doctor of Philosophy (PhD)

Department

Business Administration

Advisor(s)

Moon K. Kim

Keywords

Short-short rule repeal, Timing ability, Mutual funds, Market timing

Subject Categories

Business | Business Administration, Management, and Operations | Finance and Financial Management

Abstract

Repealed on September l, 1997, Internal Revenue Service Code Section 851 (b)(3) commonly known as the "short-short rule (SSR)" or "the 30 percent gross income test" was a burden for fund managers trying to manage their portfolio in an efficient, timely, and active manner. Several changes to portfolio management and trading activity in the mutual fund industry have been anticipated since the short-short rule repeal. Funds can be free from administrative strain and have greater flexibility in the selection of hedging, trading, and investment strategies as well as market liquidity. In other words, the SSR repeal allows fund managers to engage in new trading strategies involving short-term trades.

The objective of this study is to investigate the effects of repealing the short-short rule on the market timing ability, risk characteristics, and trading activities of mutual funds. With respect to the market timing ability, I propose a hypothesis that the short-short rule was the reason for managers' negative market timing ability. It is assumed that the mutual fund managers could not follow market movements while complying with the short-short rule. Changes in the risk, risk adjusted performance, and risk management of mutual funds are also examined. Moreover, differences in the turnover ratio, expense ratio, and short-term capital gains before and after the short-short rule repeal are studied.

The results of this study on the short-short rule repeal lead to three observations. First, it is clearly observed that market timing ability for mutual funds is improved. In three market timing models with three kinds of regression estimators, the average changes in timing ability after the SSR repeal display a statistically significant positive sign. In particular, it is found that fund managers have a positive market timing ability beyond a positive change of ability after the SSR repeal in Goetzmann et al.'s extension model. Second, the risk measures including beta, idiosyncratic risk, and market risk-adjusted risk for pre-SSR repeal, clearly show an increase after SSR repeal. The abnormal returns of funds are also improved. Jensen's alpha and the mean difference test show that the abnormal performance of funds is enhanced after the SSR repeal. Meanwhile, the cumulative abnormal returns (CAR) exhibit a downward pattern right after the SSR repeal. In terms of risk management, it is detected that fund managers reduce the size of risk change on prior performance after the SSR repeal. Third, the expense ratio and the percent of cash holding position significantly drop, while the turnover ratio shows a marginal increase after the SSR repeal, which is contrary to expectation.

This research makes major contributions in three ways. First, this is the first empirical study on the impact of the abolition of the short-short rule upon the mutual fund industry. No research has attempted to address changes in the characteristics of mutual funds such as trading activity or risk management even though more than five years have passed since the rule was eliminated. Second, the short-short rule repeal can show that the market timing ability of fund managers is not negative. In addition to the cash flow, the option-like, and the mismatch hypotheses, the short-short rule hypothesis can contribute to explaining the perverse market timing ability of mutual funds managers. Third, this study could help answer why the use of derivatives recently increased in the mutual fund industry.

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