Abstract
If some mutual fund managers have the ability to outperform benchmarks on a risk-adjusted basis, then a natural question to ask is where they should concentrate their efforts. Stocks that display high volatility relative to the benchmark may occasionally offer greater opportunities to investors who are better informed about fundamental values than the market. As a result, skilled investors may end up having greater weights on stocks with high idiosyncratic risk and, in consequence, the volatility of the stocks in an investor's portfolio may indicate the investor's degree of skill. I propose a model that captures this intuition in which managers differ in their ability first to pick stocks, and second to predict future stock price increases with precision. I examine the stock portfolios of mutual funds and find that the mutual fund industry in general favors stocks with high idiosyncratic volatility: the average idiosyncratic volatility of the stocks in a mutual fund portfolio is 3-4 percent higher than the benchmark. Funds which hold stocks with higher idiosyncratic volatility have higher future returns and higher future inflows on average, regardless of the time interval and approaches to adjust return for risk. In a successful manager's portfolio, high idiosyncratic volatility stocks outperform the remainder, indicating skill is most deployed in stocks with high volatility, and this is not the case for unsuccessful managers.
Published Version
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