Detecting Superior Mutual Fund Managers: Evidence from Copycats
University of Waterloo
University of Missouri, Columbia
Raghavendra Rau
University of Cambridge
September 15, 2014
Review of Asset Pricing Studies, Forthcoming
Abstract:
We examine the ex ante ability of investors to identify superior mutual fund managers among the investor set likely most able, and with the greatest incentive to do so, their rivals. Identifying actual copycat funds via comparisons of trading in consecutive periods, we find little evidence to suggest that managers are able to detect superior funds. Copycats select funds with high prior performance and investment inflows, and the performance of the target fund reverses following copying initiation. If superior managers exist, our results suggest that the source of skill lies in private information obtained by these managers. These results are consistent with information models indicating that private, but not public, information can be profitable.
Detecting Superior Mutual Fund Managers: Evidence from Copycats
Despite nearly a half-century of academic research, starting with Jensen (1968), the literature has not been able to conclusively establish whether mutual fund managers have superior ability to generate excess returns above a risk-matched benchmark on an after-cost basis. For example, Fama and French (2010) show that equity mutual funds earned a negative 85-basis-point annual return on average, relative to the Carhart (1997) four-factor model. However, a number of recent studies have shown that some active equity managers appear to earn positive excess returns by actively rebalancing their portfolios. For example, Mamaysky, Spiegel, and Zhang (2008) use a Kalman filter model to track dynamic mutual factor loadings and show that some mutual fund managers time their trades and earn positive excess returns. Dyck, Lins, and Pomorski (2013) show active management outperforms passive management in emerging markets, suggesting that the value of active management depends on the efficiency of the underlying market. Cremers and Petajisto (2009) show that managers whose portfolio holdings differ the most from their benchmarks, a measure they term “active share,” earn significant excess returns. Cohen, Polk, and Silli (2010) show that the best ideas of active managers (the largest holdings in their portfolio) tend to strongly outperform smaller positions in their portfolio.
While the “active share” literature argues that superior managers exist, the “smart money” literature provides mixed evidence on investor ability to identify these managers. For example, Gruber (1996) and Zheng (1999) report that funds that experience inflows have superior short-term future performance relative to funds that realize outflows. However, Sapp and Tiwari (2004) argue that this relation is explained by momentum in stock returns, and Lou (2012) shows that the smart-money effect can be fully explained by predictable flow-driven returns.
What remains uncertain is whether superior mutual fund managers can be identified ex ante. In this paper, we examine whether superior performers can be detected ex ante by the persons who are likely most able, and have the greatest incentive to do so, their rivals. Specifically, we analyze the behavior and performance of funds that choose to copy a rival fund as opposed to implementing their own investment strategies. We examine three issues: First, how does the number of copycat funds change over time? Second, does the target fund indeed outperform standard benchmarks after being selected? Third, what is the source of the superior fund manager skill? Both the propensity of funds to use copycat strategies and the subsequent performance of the target funds serve as proxies for fund manager perceptions of the viability of such a strategy and their ex ante ability to detect superior fund managers.
What kinds of funds are most likely to copy other funds? We first note that the prior literature has typically defined managerial skill in terms of the manager’s ability to pick superior portfolios (or to set timely asset allocation strategies). Copycatting involves a different type of skill. Practical implementation of a copycat strategy requires little skill, with the process being akin to running an index fund.
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