A reappraisal of luck versus skill in the cross-section of mutual fund returns

Rong Huang,Dimitrios Asteriou,William Pouliot

doi:10.1016/j.jebo.2020.03.032

Abstract

The first contribution we make to research on measuring U.S. mutual fund performance is to show that the cross-section bootstrap procedure used in one prominent publication on this topic can easily accommodate conditional asset pricing models. Using this result, we reestimate US fund performance using the conditional asset pricing model of Ferson and Schadt (1996) for the period of time covering January 1984 to September 2006, the same period of time used in this prominent publication. Unlike most of the current research on the performance of U.S. mutual funds, including the latter research, the estimates of fund performance produced here suggest that some funds, on a net return basis, performed very well over this period. Our second contribution is to update the U.S. mutual fund data to the end of 2018 and then to re-estimate fund performance over this longer period of time. These results show that fund performance, on a net return basis, is poor, confirming the findings of previous research that used data ending before 2018. The third contribution is to provide a detailed guide on how the mutual fund data widely used in this literature is constructed. Until now much of the information required to do this has not been made widely available. Our last contribution is to make some policy recommendations that should better align fund manager incentives with the interests of investors, an alignment which current practices have hindered.

Highlights

Research undertaken here is motivated by the paper of Fama and French (2010) which is a recent contribution to a long running debate on the performance on actively managed U.S mutual funds
Anticipating some of the results that come later on, our estimations and simulations show that the negative results reported by F&F regarding the performance of actively managed U.S mutual funds, for the period 1984 to September 2006, no longer holds when a more general equilibrium asset pricing model is used to estimate fund performance, a result which supports the conclusions of Huang et al (2019)
Because F&F examine fund performance from the perspective of equilibrium accounting, they estimate equal-weighted (EW)8 and value-weighted (VW)9 aggregate return level regressions to determine whether funds on average produce abnormal returns and whether aggregate wealth invested in funds produces abnormal returns

Summary

Introduction

Research undertaken here is motivated by the paper of Fama and French (2010) (hereafter F&F) which is a recent contribution to a long running debate on the performance on actively managed U.S mutual funds. Anticipating some of the results that come later on, our estimations and simulations show that the negative results reported by F&F regarding the performance of actively managed U.S mutual funds, for the period 1984 to September 2006, no longer holds when a more general equilibrium asset pricing model is used to estimate fund performance, a result which supports the conclusions of Huang et al (2019) The latter authors find a small percentage of U.S mutual funds produce positive alpha using returns data that ends March 2015, data that is somewhat dated compared to data used here which is up-to-date to December 2018. Appendix A provides information on how to construct the mutual fund dataset used here which reconstructs the data used by F&F; and Appendix B tabulates the cross-section distribution of t(α) using unconditional 3F-CAPM when funds have at least sixteen months of returns data

The mutual fund data

Conditional and unconditional asset pricing models

Results from estimating aggregate level regressions

Estimating and simulating the cross-section of true α

Billion

Additional tests for sub-samples and turbulent periods

Changes to financial regulation and compensation practices for mutual funds

Conclusions

Selecting US equity mutual funds

Excluding passively managed funds

Checks of assigned fund objective

Selecting mutual fund returns