Investment Objective Subgroups of Mutual Funds and Market Re- turn Comparison. Mutual funds have attempted to differentiate their services by specializing in cer- tain sectors of the stock market and adopting various investment styles. For example, growth funds claim to specialize in low book-to-market stocks, while income funds claim to specialize in high book-to-market stocks. The question is whether such spe- cialization adds value to investors. We investigate this issue by partitioning funds based on their self-declared investment objectives (aggressive, growth, income, and growth & income). In this Section, we use a stochastic dominance approach to exam- ine whether some styles of mutual funds perform better than others or better than the market. Figure 2 and Figure 3 plot the CDF of four classes of mutual fund and the market returns. Once again, all of the CDFs cross, so we do not expect to find first order stochastic dominance. Table 5 summarizes the stochastic dominance results for the four mutual fund classes and the market both before and after management fees have been deducted. Before deducting management fees, aggressive funds are third order stochastically dominated by each of the other three classes of mutual funds and also the market. After deducting management fees, aggressive funds are still third order dominated by each of the other three classes of mutual funds and second order dominated by the market. This test result shows that aggressive funds on average are inferior to the other three mutual fund classes and the market for all prudent investors with or without considering management fees. Also, on a net return basis, all risk-averse investors prefer the market to average aggressive funds. The underperformance of aggressive funds is not surprising given the high exposure to market risk and high betas. Hong and Sraer (2016) provide a theory for why high beta assets are prone to speculative overpricing. They point out that when investors disagree about the stock market’s prospects, high beta assets are more sensitive to this aggregate disagreement. Thus, high beta assets experience a greater divergence of opinion about their payoffs and are overpriced due to short-sales constraints. The stochastic test result confirms that risk-averse individuals do not prefer aggressive funds. This suggests that the major flow to aggressive funds is probably made by investors with certain non-concave utility functions. The absence of second order stochastic dominance between income funds and the market means that certain risk-av...
