Best Kind of Stocks to Pick?

Are stock pickers more likely to out-pick the market by focusing on stocks that resist market efficiency? In their December 2008 paper entitled “When is Stock-Picking Likely to be Successful? Evidence from Mutual Funds”, Ying Duan, Gang Hu and David McLean examine changes in quarterly holdings of mutual funds to measure how the stock-picking performance of fund managers varies with stock idiosyncratic volatility (volatility that indicates risk factors different from those of the overall stock market). Using quarterly mutual fund stock holdings data and monthly stock return data for the period 1980-2003, they conclude that:

• Based on both raw and four-factor (market, size, book-to-market and momentum) risk-adjusted returns, mutual fund managers exhibit stock-picking ability only among stocks with high idiosyncratic volatility, perhaps due to relatively:
  • High costs of diversification/arbitrage that inhibit pricing efficiency.
  • Important streams of firm-specific information that reward close attention and correct interpretation.
• This stock-picking ability is stronger at three-month and six-month horizons than at a 12-month horizon, suggesting the importance of medium-term events.
• The stock-picking ability of the average mutual fund manager declines markedly (essentially disappears) from the 1980-1994 subperiod to the 1995-2003 subperiod, perhaps due to dramatic proliferation of both mutual funds and hedge funds in the late 1990s (exhausting supplies of mispricing and manager ability). However, fund managers do better trading stocks with high idiosyncratic volatility than low idiosyncratic volatility in both subperiods.

In summary, stock pickers may want to focus on stocks with high idiosyncratic volatility.

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