An Investment-Based Investigation of Mutual Fund Performance

Abstract

Standard benchmarks that build exclusively on the size, value, and momentum effects can be problematic for evaluating mutual funds. Motivated by investment-based asset pricing, I show that investment and profitability convey useful information about future fund returns. However, such information is not sufficiently taken into account by the standard benchmarks. As a result, funds favoring low investment or high profitability stocks appear to outperform, while funds favoring the opposite appear to underperform. Accounting for investment and profitability can change performance estimates significantly, and helps explain the good performance of funds with growth orientation (Daniel, Grinblatt, Titman, and Wermers (1997)), high active share (Cremers and Petajisto (2009)), or small size (Chen, Hong, Huang, and Kubik (2004)). A new benchmark that incorporate investment and profitability accounts for the cross-section of stock returns better and tracks mutual fund returns more closely.