The Importance of Being Active

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A number of research studies conclude that active US equity open-end mutual funds underperform on average and that overall manager skill is diminishing. This contrasts with other studies documenting systematic ways investors can identify managers who subsequently outperform. In this study, involving all active US equity mutual funds over the period February 1980 through February 2009 (resulting in 403,577 observations), I show that both return and the chance of beating the market decline with the age of the average fund. Buying and holding the typical active US equity fund is a recipe for underperformance. On the other hand, I show that funds actively placing stock selection bets and enjoying recent return success earn increasingly superior returns and experience an improved likelihood of beating the market as the fund ages. This argues for the importance of being truly active as a fund manager. Manager skill increases with fund age as long as the manager continues to actively place stock bets.

The importance of being active

Considerable evidence (see Baker et. al 2004, Brands et. al. 2006, Cohen et. al. 2009, Kosowski et. al. 2006, Wermers et. al. 2000, and Wermers et. al. 2007, among others) shows that active US equity open end mutual fund managers are skilled stock pickers. However, it is difficult for investors to benefit from this skill as long-term studies (see Barras et. al. 2008 and Fama and French 2008, among others) show the average active fund underperforming an appropriately selected benchmark after fees. What’s more, these same studies show performance declining as the fund ages and average fund performance deteriorating in recent years.

In contrast, other studies (see Amihud and Goyenko 2008, Cohen et. al. 2005, Cremers and Petajisto 2008, Howard and Callahan 2006, Kacperczyk et. al. 2005, and Wermers 2002, among others) document systematic ways to identify funds that subsequently outperform net of fees. These studies show funds that 1) actively place stock bets (as measured by a low benchmark R2, high active share, large tracking error, or high “style drift”) and 2) have enjoyed recent success, subsequently outperform for up to four quarters.

In an attempt to explain these seemingly contradictory results, I compare the performance of the average active US equity open-end mutual fund to a sub-sample of funds selected using the recent methodology of Amihud and Goyenko (2008). They show that the funds with the lowest quintile trailing one-year market R2 and the highest quintile trailing one-year return significantly outperform over the subsequent year. In other words, funds with strong performance that don’t hug indices (low R2) are more likely to perform well in the future.  Amihud and Goyenko further demonstrate that each of these selection criteria contributes to the subsequent superior performance.

Based on the results reported below, I come to two conclusions:

  1. The typical fund starts out life underperforming after fees and gets worse with age. The declining performance is most likely the result of powerful industry incentives to get large, to replace solo managers with teams, and to stay in a specific style box as the fund manager becomes a fund distributor. The evidence reported below reveals these incentives dictate a typical time path of declining fund performance.
  2. On the other hand, if a fund continues to place active stock bets, performance starts out strong and gets stronger with age. This means that a subset of fund managers are skilled enough stock pickers to more that cover their fees, while stock picking skill improves with fund age (and more than likely with manger experience). The average 26-30 year old fund that continues to actively place stock bets generates an excess net of fees return exceeding 1% monthly while beating the market an astounding 84% of the time.

The implication for investors is that it is very difficult to buy and hold so-called “active” funds and generate superior returns, since average fund returns diminish over time. Instead, it is necessary to ensure that a fund continues to actively place stock bets. Diligence in this regard is rewarded with superior returns.