COLLEGE PARK, Md. (Aug. 12, 2015) –Three academics have developed a formula to predict mutual fund manager performance. It’s based on their finding that some fund managers beat the market based on how much competition they have: Less is better.

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The findings are in the working paper Mutual Fund Competition, Managerial Skill and Alpha Persistence by professors Gerard Hoberg, University of Southern California’s Marshall School of Business; Nitin Kumar, Indian School of Business; and N.R. Prabhala, University of Maryland’s Robert H. Smith School of Business.

The researchers’ method, “peer alpha assessment,” relies on identifying the peers of a fund based on how similar their holdings are. This requires categorizing stocks based on such metrics as company size and book-to-market value.

The researchers examined 3,390 unique funds from 1980 through 2010. They re-analyzed peer groups quarterly, meaning that a given fund’s peers were constantly shifting (as fund size or strategy changed). Peers from the new methods overlap only partly with categories widely known to consumers, such as those used by Lipper.

Some funds had just a few dozen rivals while others had hundreds. Depending on the number of peers the funds had, the authors placed funds into high, medium and low competition categories.

When fund performance was examined, a fund’s past performance relative to its peers served as a predictor of its future performance. That suggests some fund managers did possess a measurable ability to spot valuable investments, whether they achieved this through skill, access to better information, or some other means. But the more competition a fund faced, the less likely it was to maintain an advantage—over both the short and the long term, says Prabhala.

In the high-competition space, alpha persistence was close to zero. In the low-competition category, however, the funds in the top decile of performers maintained an advantage of 185 basis points (1.85 percentage points) over those in the lowest decile, even after controlling for variables such as fund size or turnover.

“If a given manager does well, the other funds are watching, and possibly copying successful strategies… Competition therefore helps determine whether the fund will continue to outperform its peers,” Prabhala says.

Read more in this Smith Brain Trust post.

Mutual Fund Competition, Managerial Skill, And Alpha Persistence

As of December 2013, US mutual funds manage close to $15 trillion in assets. Of these, 4,540 are open ended equity funds holding with assets worth $7.7 trillion. The shares held by mutual funds represent 96 million households and account for 29% of the value of the outstanding shares in the U.S. market (ICI Factbook, 2014).

Can mutual fund managers generate positive alpha? If so, does alpha persist? These are fundamental questions in the mutual funds literature. Research on these issues dates back to at least Jensen (1968), who finds that neither funds in aggregate, nor individual funds, perform better than what would be expected by random chance. Jensen's skepticism finds support in work such as Elton, Gruber, Das, and Hlavka (1993), Carhart (1997), Busse, Goyal, and Wahal (2010) and Fama and French (2010). However, Bollen and Busse (2005), Kosowski, Timmermann, Wermers, and White (2006), Cremers and Petajisto (2009), and Kacperczyk, Nieuwerburgh, and Veldkamp (2014) find evidence of performance persistence. What economic forces limit the ability of managers to generate sustained alpha? Berk and Green (2004) (BG) articulate perhaps the most in uential line of thought on this issue.

They emphasize scale diseconomies in asset management. BG argue that fund manager talent is in short supply. Talented managers attract additional money flows from investors, which increases the assets under management. Under diseconomies of scale, fund alpha decreases, to zero in equilibrium. This view is consistent with stylized facts in the fund industry.1 Pastor and Stambaugh (2012) and Pastor, Stambaugh, and Taylor (2014) argue that diseconomies operate at the aggregate fund industry level rather than the individual fund level.

Alpha Mutual Fund Manager Performance

Alpha Mutual Fund Manager Performance

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