Some stock mutual fund managers have skill

5 Jun 2010 by Jim Fickett.

In an academic paper on how stock mutual fund managers may choose to focus their attention, and with what results, the main practical conclusions are: (1) macroeconomic understanding is more important during recessions, and stock picking during expansions; (2) managed funds provide more value during recessions; (3) there do exist skilled managers who provide outperformance during both halves of the business cycle.

There has been much discussion about whether mutual fund managers add real value. In an Oct 2009 paper entitled Attention Allocation Over the Business Cycle, professors Kacperczyk, Nieuwerburgh and Veldkamp at the NYU Stern School of Business give a qualified yes – some do. And just as important, it is possible to find such managers and understand what kind of value they add.

A primary concern of the authors is understanding how busy people allocate their attention among many possible sources of information, and their discoveries about good managers are motivated by models of attention allocation. Here is an extract from the introduction of the paper:

Do investment managers add value for their clients? … evidence of negative average “alpha” has led many to conclude that investment managers have no skill. By developing a theory of managers’ information and investment choices and finding evidence for its predictions in the mutual fund industry data, we conclude that the data are consistent with a world in which a small fraction of investment managers have skill. However, the model is also consistent with the empirical literature’s finding that skill is hard to detect, on average. The model identifies recessions as times when information choices lead to investment choices that are more revealing of skill.

[link added]

If one is less interested in mathematical models, the empirical results of the study still make sense on their own. It is on the empirical results that we concentrate here.

One of the main results of the paper is that different investment skills are relevant during different parts of the business cycle. Attention to macroeconomic variables is most important during recessions, while attention to individual stocks is most important during expansions:

we estimate the covariance of each fund’s portfolio holdings with the aggregate payoff shock, proxied by innovations in industrial production growth. We call this covariance reliance on aggregate information (RAI). RAI indicates a manager’s ability to time the market by increasing (decreasing) her portfolio positions in anticipation of good (bad) macroeconomic news. We find that the average RAI across funds is higher in recessions. We also calculate the covariance of a fund’s portfolio holdings with asset-specific shocks, proxied by innovations in earnings. We call this variable reliance on stock-specific information (RSI). RSI measures managers’ ability to pick stocks that subsequently experience unexpectedly high earnings. We find that RSI is higher in expansions.

Connected with this, the skill of a fund manager is more important during recessions. The differences between funds is greater in recessions than in expansions, and mutual funds in general provide more value in recessions:

Figure 1 [not included here] shows a 30% increase of the cross-sectional standard deviation of fund alphas in recessions for our mutual fund data. …

Third, we document [average] fund outperformance in recessions. Risk-adjusted excess fund returns (alphas) are around 1.8 to 2.4% per year higher in recessions, depending on the specification. Gross alphas (before fees) are not statistically different from zero in expansions, but they are positive in recessions. Net alphas (after fees) are negative in expansions and positive in recessions. These cyclical differences are statistically and economically significant. Indeed, Figure 2 shows that, over the period 1980-2005, actively managed mutual funds have earned 2.1% risk-adjusted excess returns (alphas) per year in recessions but only 0.3% in expansions. What remains for investors (net of fees) is 1.0% in recessions and -0.9% in expansions; the difference of 1.9% per year is both economically and statistically significant.

One might think that some funds are good at recessions and some at expansions. While this may partly be true, the authors go on to show that some managers show outperformance in both halves of the cycle, and these managers show some other interesting traits, as well:

To show that skilled managers exist, we select the top 25 percent of funds in terms of their stock-picking ability in expansions and show that the same group has significant market-timing ability in recessions; the other funds show no such market-timing ability. Furthermore, these funds have higher unconditional returns. They tend to manage smaller, more active funds. By matching fund-level to manager-level data, we find that these skilled managers are more likely to attract new money flows and are more likely to depart later in their careers to hedge funds. Presumably, both are market-based reflections of their ability. Finally, we construct a skill index based on observables and show that it is persistent and that it predicts future performance.

Clearly one can think about applying all this in choosing fund managers. An additional lesson is that one should probably place macroeconomics first in one's personal investment decisions, especially in bad times, with stock picking second (or perhaps third).

If you are interested in following up on this skill index, it is composed of two parts, a timing measure and a stock picking measure. The main ideas, and points in the paper where you can find more details, are as follows:

  • The timing measure is defined in equation 11 on page 12 of the paper. A simplified version of this measure would be the extent to which a manager gets into cyclical stocks for expansions and out of them for recessions.
  • The picking measure is defined in equation 13 on page 13 of the paper. The main idea is to measure the gains and losses of a manager in buying stocks before they make a move that is independent of the rest of the market.
  • The skill index is defined at the bottom of page 26. It is a weighted sum of the timing and picking measures, with timing getting most of the weight in recessions and picking getting most of the weight in expansions.

One final note of caution. As we all know from our own performance, as well as from trusting others with our money, past performance is not always a guide to future results. Although the authors show skill does exist and does persist, they also show that when a manager is picked on the basis of high performance during one period, on average the performance is somewhat lower in later periods (click for larger image):

That far right point on the top line does suggest (1) that one should evaluate long-term performance, and (2) that simple, conservative strategies, without too much active management, still have their place.