We examine the "marketability hypothesis," which states that stock splits enhance the attractiveness of shares to investors by restoring prices to a preferred trading range. We examine splits of mutual fund shares because they provide a clean testing ground for the marketability hypothesis, since the conventional rationales for common stock splits do not apply. We find that splitting funds experience significant increases in net assets and shareholders. Stock splits do appear to enhance marketability.

Although practitioners suggest that marketability is the primary reason for executing a split (e.g., Baker and Gallagher, 1980; Baker and Powell, 1993), few papers have rigorously explored this possibility. However, academic research on common stock splits has found some support for the marketability hypothesis. For example, Lamoureux and Poon (1987) and Maloney and Mulherin (1992) report that the number of shareholders increases following common stock splits. Schultz (1999) shows that the number of small orders increases following a stock split, and that the bulk of these orders are buys. [2] Angel, Brooks, and Mathew (1997) show that trading activity by small investors increases following a stock split. Fernando, Krishnamurthy, and Spindt (1999) show that firms going public appear to use the offering price to influence investor interest in the issue.

According to the trading-range hypothesis, round-lot constraints and transaction cost considerations result in a preferred price level, which is restored by the split. According to the signaling hypothesis, managers implement stock splits to communicate favorable private information about the firm's prospects.

However, these competing explanations do not fit very well the case of mutual fund splits. [3] Existing transaction cost and constraint-driven explanations of a trading range do not apply, since mutual funds do not trade in ticks and any transaction costs or trade size restrictions are not related to share prices. Also, in a recent paper, Rozeff (1998) finds that splitting funds do not subsequently outperform non-splitting funds. Rozeff argues that this result is inconsistent with managerial signaling. Therefore, mutual fund splits provide a relatively clean testing ground for the marketability hypothesis.

The marketability hypothesis states that a splitting fund will attract new money and new shareholders. Rozeff (1998) examines 167 stock splits by mutual funds. He finds no evidence of increased inflow following splits, a finding that appears to contradict the marketability hypothesis. However, Rozeff uses annual data and matches funds based on asset growth in the year the split occurred. This "screen" is coarse and thus might not detect noisy excess inflow that could only occur after the split.

In this paper, we extend Rozeff's work by examining data on 194 stock splits mutual funds executed between 1978 and 1993. We test for excess inflow by using quarterly data, and we control matching funds based on asset growth, performance, and size in the year before the split. We use quarterly data to estimate the timing of any excess inflow more precisely, and we match on prior period characteristics to minimize look-ahead bias in the results.

We find evidence of excess inflow into splitting funds in the quarter of the split and in the two subsequent quarters. The cumulative excess inflow of new money into the splitting funds during the two quarters after the split averages $8.5 million or about 5.6% of net assets.[4] We also find that relative to control funds, there is a significant increase in the number of shareholders in the split year. These findings support the hypothesis that splits improve marketability by restoring share prices to a preferred trading range.

We supplement our empirical work with survey evidence on the views of 52 mutual fund managers. Their responses are also consistent with the marketability hypothesis. These managers generally believe that a lower net asset value (NAV) per share attracts the attention of small investors. Moreover, they do not believe that mutual fund splits convey favorable information about future fund performance.

Conventional justifications of a preferred trading range do not explain why investors respond favorably to mutual fund splits. Although we cannot rule out some as-yet-undiscovered rational explanation for investors' positive response to splits, there may be behavioral (e.g., herding, as in Bikhchandani, Hirshleifer, and Welch, 1992) or cognitive (e.g., framing, as in Thaler, 1985) factors that lead investors to prefer a trading range. If behavioral or cognitive factors can explain mutual fund splits, they might also be able to explain common stock splits. Indeed, the rationale provided by our findings for why fund managers undertake splits is strikingly similar to the rationale corporate managers cite for undertaking splits of common stock.

Thus, behavioral or cognitive factors could also give rise to a preferred trading range. If so, managers would undertake splits in recognition of these factors to enhance the marketability of their funds. If the marketability hypothesis holds, we would expect managers to set post-split prices close to industry averages and for splits to attract new money and investors.

We selected all open-end mutual funds identified in the CDA Weisenberger Investment Companies Yearbook as executing a split during the period 1978 to 1993. [10] We also searched the CDA Weisenberger Mutual Funds Update from 1982 to 1993, the mutual funds section of the Nasdaq OTC Daily Stock Price Record from 1981 to 1993, and the Moody's Dividend Record and the S&P Dividend Record, both from 1978 to 1993 for additional splitting funds.

Our final sample consists of 194 mutual funds that executed a split during the 1978 to 1993 period. Approximately 1% of all mutual funds split in a given year during this period.

FOR SHARON AND DARRYL WARD, THE ROAD TO wealth-building is paved with mutual funds. "We're in our 30s, so we have many years of investing before we retire," says Sharon, a financial programs specialist with the U.S. Treasury Department in Birmingham, Alabama. "Therefore, we invest mainly in stocks and stock funds where the long-term returns likely will be superior. I personally like to invest through mutual funds because I feel the diversified holdings provide safety."

Once a conservative investor, Sharon has evolved into a moderate risk-taker. On the other hand, her husband, Darryl, a mortgage banker, is a more aggressive fund picker. "We don't own a lot of small-company or international stocks," he says, "so our portfolio is tilted toward large- and mid-caps. I like to see a lot of technology stocks in the portfolio before I invest: I know they're volatile, but I think the long-term returns will be worth the risks."

As a result, the Wards have crafted an investment program that is a mix of moderate and aggressive funds. And as they have structured their portfolio, they have placed a high premium on consistent returns. "A few years ago, a specialized technology fund was suggested to me," says Darryl. "However, it had just returned 112% the previous year, so I was reluctant to invest because I didn't think it could repeat that performance. Instead, I invested in Fidelity Select Software and Computer Services Fund (FSCSX), which had a record that was good but not as great." Fortunately, he didn't regret that choice. Since he's held the investment, Fidelity Select has gained more than 30% per year.

Many investors go through the same arduous process as the Wards when it comes to figuring out the next hot fund. The more misguided, however, conduct research akin to throwing darts at a board. So just how can you truly determine which funds will give you the best bang for your buck? To help you make this decision, BLACK ENTERPRISE consulted Morningstar, the Chicago-based mutual fund tracking service. Susan Dziubinski, editor of Morningstar Fund Investor, a monthly newsletter, has reviewed and helped us prepare a list of 12 hot mutual funds for the new millennium (see chart). OK, they may not last a thousand years. But the process that she used to select the funds is one that can easily be passed on to any generation of investors.

Instead of established funds, Dziubinski is drawn to young `uns--those vehicles that have yet to establish track records of more than a half decade. Why new funds? "Young, relatively small funds have some advantages," she says. "They may be more flexible than large, established funds, so they can take advantage of emerging trends."

Some rookies offer lower costs--especially index funds. Byron Snearl of Los Angeles counts himself among those who have found the advantages of such vehicles. "I don't have the time to study the funds closely," says the retiree who now manages his own rental properties, "so I invest through index funds. They mimic the market and I'll settle for those kinds of returns. They're low-cost, tax-efficient and don't present the risks of picking the wrong fund manager."

The bargain-hunting Snearl, of course, prefers "no-load" funds--those without sales charges--because they tend to offer solid returns at cheap prices. His preference: low-cost index funds from Vanguard Group. "I use dollar-cost-averaging to lower my risks even more," he says, investing $400 each month, which gives him the opportunity to buy more shares when prices drop.

Christopher Solmssen knows more about stock picking than most mutual fund investors, so when he extols Selected American Shares, it's worth paying heed. Solmssen is a 30-year-old stock analyst with Sun-America Asset Management, in New York City. He notes that Shelby Davis, who managed Selected from 1993 until early 1997, and Davis's son Chris, who has assumed the reins from his father, practice a "really sound, long-term philosophy of investing with a five- to ten-year horizon, not week to week like some funds." Moreover, he says" with Shelby Davis, who remains active in the fund's management, you get one of the most talented investors in the business. "Who else has a 25-year track record of outperforming the market in both bull and bear markets?" asks Solmssen.

For a fund that specializes in large, undervalued stocks, Selected American -- one of only 253 diversified U.S. stock funds to have outperformed Standard & Poor's 500-stock index last year -- is fairly aggressive. Because Solmssen probably won't be tapping his savings for at least 30 years, that makes it ideal for his IRA and for this long-term retirement portfolio. The fund invests in large, moderate-growth companies -- typically those showing earnings gains of 7% to 15% a year. The Davises try to buy at favorable prices, often when a company is out of favor, and then hold the stock for at least five to seven years. "People call us value investors because we're price sensitive, but we don't want any stock that doesn't have growth potential," says Chris, who likens himself to a quarterback and his father to the coach.

High-tech stocks are a hallmark of Harbor Capital Appreciation. Spiros "Sig" Segalas, manager since 1990, recently had about about 28% of assets in technology stocks. That weighting isn't surprising for someone who specializes in finding large, rapidly growing companies. Unlike the Davises, who consider a 15% growth rate the ceiling, Segalas picks stocks that typically deliver earnings growth of al least 15%.

Berger New Generation, a newcomer to "Best Funds," buys rapidly growing companies, too, but smaller ones than the Harbor fund would consider. By the rules of its prospectus, it can Invest in companies of any size that are capable of changing the way things are done in their sectors. But the fund has a strong small-stock bias because, says manager William Keithler, "by definition, a lot of the innovation occurs with smaller companies, and the impact on those companies, if successful, is a lot more significant." Keithler expects the earnings of the fund's holdings to soar 52% this year.

Complementing New Generation is another "Best Funds" newcomer, Westcore Small-Cap Opportunity which invests in small, undervalued companies. Varilyn Schock, who has run Small-Cap since its inception in late 1993, looks for companies that are "mispriced" but have improving business outlooks. She uses a proprietary system that ranks companies by such measures as the ratios of price to earnings, book value and cash flow, then identifies the cheapest 10% of stocks in ten different economic sectors. These candidates for inclusion in the fund get a going-over by Schock and her analysts, who study such matters as a company's products, management and regulatory issues.

Artisan international rounds out the retirement portfolio. It is coming off a mediocre year, having returned just 3.5% in 1997, slightly less than the average diversified overseas fund. Manager Mark Yockey compiled an above-average record at both Artisan and United International, by first identifying countries that provide a good environment for growth and then searching for reasonably priced growth stocks. Yockey attributes his 1997 performance to not hedging against currency fluctuations, holding lots of small-company stocks, and owning stocks listed in Hong Kong (11% of assets at midyear) and Japan (9%). By early 1998 those figures had been trimmed to 5% and 3%, respectively, with three-fourths of Artisan's assets in European stocks and about one-fifth in emerging markets, including Hong Kong.