Sector Fund Performance: Analysis of Cash Flow Volatility and Returns

Sector funds are an important and growing segment of the mutual fund industry. This paper analyzes the performance of 609 actively managed stock sector funds listed on the CRSP Survivor-Bias Free US Mutual Fund Database during 1972-1999. We use a five-factor model to document the following results. First, sector funds as a group neither outperform nor underperform their benchmarks. Second, sector funds experience significantly higher cash flow volatility than non-sector funds. However, conditioning returns on lagged cash flows does not alter their neutral performance. This finding differs from previous literature that documents a significant decrease in diversified stock fund performance due to cash flow volatility. Third, sector fund investors as a group do not possess the ability to pick winning sector funds or winning sectors of the stock market. This finding differs from previous literature that documents the smart money effect. For comparison, we present the performance statistics of 3,227 diversified (non-sector) stock funds during the same period. Current version: June 2005 * Department of Finance, Henry B. Tippie College of Business, University of Iowa, Iowa City, Iowa 52242-1000. Email address: [email protected]. ** Department of Finance, Henry B. Tippie College of Business, University of Iowa, Iowa City, Iowa 52242-1000. Email address: [email protected]. Corresponding author. We have benefited from the comments of seminar participants at the Iowa State University, the University of Colorado, the University of Illinois, the University of Iowa, the University of Kansas, and the University of Missouri. We wish to thank Matt Billett and Jon Garfinkel for useful comments.