Unobserved Actions of Mutual Funds

By Marcin Kacperczyk (University of British Columbia), Clemens Sialm (University of Michigan) , and Lu Zheng (University of Michigan), Social Science Research Network

This study develops a unique measure referred to as the return gap which serves as a useful tool to predict future fund performance and identify the best mutual funds. For a given month, the return gap is measured as the difference between the actual fund return and the return that would have been earned by following a buy and hold strategy based on the fund’s most recently disclosed portfolio. The goal of the return gap is to measure the impact of decisions made by mutual fund managers which are not immediately reported (or may never be disclosed) to investors.

These unobserved actions fall into several categories. Of greatest importance to fund investors are the unobserved trades made by managers between portfolio disclosure periods. If managers are skilled at selecting undervalued securities or are able to optimally time the purchases and sales of individual stocks, then it is very likely that they will outperform their previously disclosed portfolio and generate a positive return gap measure. The authors examine over 2,500 U.S. equity funds covering the time period 1984-2003. By law, funds are required to report holdings semiannually. Over the sample period, nearly 50% of the funds included in the study reported their holdings on a quarterly basis. Given the time between portfolio disclosure, there are substantial opportunities for the manager trading decisions to add (or subtract) value relative to the most recently reported portfolio.

The most important result of the study is that the return gap helps to predict future fund performance. Funds with the most favorable past return gaps outperform funds with the least favorable past return gaps in the subsequent months by an average of 3.4% per year. Relative to a broad market portfolio, the portfolio of funds with the highest past return gap generate an average return that is 1.2% per year greater than the return on a portfolio composed of all NYSE, AMEX, and NASDAQ stocks. In general, smaller funds and funds from large fund families tend to exhibit the most favorable return gaps. To ensure the validity of the results, the return gap is calculated using raw returns, risk adjusted returns (based on the Carhart model), and holdings based returns (based on the Daniel, Grinblatt, Titman, and Wermers model). All results hold regardless of the return measure used.

Overall, portfolio strategies based on the return gap are a useful tool for investors interested in generating above average returns over time.

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