Objective research to aid investing decisions
Menu
Value Allocations for September 2019 (Final)
Cash TLT LQD SPY
Momentum Allocations for September 2019 (Final)
1st ETF 2nd ETF 3rd ETF

Mutual Fund Trading Drives Performance?

Posted in Investing Expertise, Mutual/Hedge Funds

Should investors expect mutual fund managers to generate value via timely trades? In their November 2014 paper entitled “Do Funds Make More When They Trade More?”, Lubos Pastor, Robert Stambaugh and Lucian Taylor investigate the relationship between mutual fund turnover and performance. They measure mutual fund performance at a monthly frequency as gross fund return minus the return on its Morningstar benchmark index. They measure turnover over the last 12 months via a methodology that largely excludes trading due solely to fund inflows and outflows. Using returns and turnovers for 3,126 active U.S. equity mutual funds during 1979 through 2011, they find that:

  • Abnormally high trading indicates unusually strong active mutual fund performance. Specifically:
    • On average, a one standard deviation increase in fund turnover relates to a 0.65% increase in future annual performance.
    • This relationship is especially strong for small, high-fee funds, for which a one standard deviation increase in turnover indicates a 1.25% increase in future annual performance.
  • Results are consistent with high-fee funds having greater skill in exploiting time-varying profit
    opportunities and with small funds being better able to exploit such opportunities.
  • The positive relationship between turnover and future fund performance weakens when the average correlation of fund performance is high (indicating that funds are trading similarly).
  • On average, funds trade more (and future performance is especially high) when investor sentiment is high, the dispersion of returns among stocks is high or when stock market liquidity is low.
  • A hedge strategy that is each month long each mutual fund and short its benchmark in an amount scaled to prior-year mutual fund turnover generates an annual Sharpe ratio of 0.79.
  • The third of mutual funds with the highest ratios of prior-year turnover to longer-term average turnover outperforms the third with the lowest ratios. However, on average, even the top third underperforms associated benchmark indexes on a net basis. 

In summary, evidence indicates that mutual fund managers can generate value via timely stock trades, but that this value generally translates into higher fees rather than benchmark outperformance for investors.

More positively, results suggest that individual investors who can trade as well as fund managers can outperform other investors.

Cautions regarding findings include:

  • As noted, the study mostly uses gross mutual fund returns. Mutual fund investors must pay fees, and thereby realize only net returns.
  • The hedge strategy test does not account for the feasibility/cost of shorting benchmark indexes, nor potential constraints on frequent trading of some mutual funds.
Why not subscribe to our premium content?
It costs less than a single trading commission. Learn more here.
Daily Email Updates
Login
Research Categories
Recent Research
Popular Posts