Abstract
This study provides evidence for a positive association between mutual fund holdings' implied cost of capital (ICC) and future performance. Consistent with large transaction costs of ICC-based investments impeding their exploitation and employing a ICC-based strategy reflecting skill, family-level trading efficiency and manager-level SAT score positively correlate with fund-level ICC. A negative association between ICC and mid-year risk shifting corroborates the notion of fund managers decisively choosing and relying on high-ICC strategies. Institutional investors able to identify funds with high ICC direct their investments accordingly, whereas flows of retail funds are unaffected, consistent with limited investor attention and financial literacy.
Highlights
_I am from the Department of Finance, University of Cologne, and member of the Centre for Financial
This paper provides evidence for mutual fund managers being able to seize the potential of an ICCbased strategy, in particular due to their access to efficient trading opportunities
What kind of trading strategies do skillful mutual fund managers employ and how can investors identify them? research documents that portfolio selection based on firms’ implied cost of capital (ICC) in general founders on necessary transaction costs, mutual fund managers seem to be able to bring to bearing corresponding return potentials
Summary
The central metric used in this study derives from firms’ ICC. Based on a certain corporate valuation model, they represent the rate of return implied by current price and forecasts of future pay-offs, which in turn are determined by earnings and their growth. Such, most generally, ICC solve. Fund-level ICCs are distinguishable between analyst-based ICCs on the one hand and ICCs with mechanical earnings forecasts as inputs on the other; whereas the latter, with means of roughly 6.5%, closely resemble each other, ICCs based on analysts are approximately 50% larger This is consistent with the positive analyst forecast bias documented in literature [e.g., Lim (2001), Hou, van Dijk, and Zhang (2012), Mohanram and Gode (2013), and Larocque (2013)], as, ceteris paribus, higher expected pay-offs in equation (1) imply higher ICC. These findings may be relevant for persistence of possible performance-predicting capabilities of ICCs and, related, turnover in portfolio-based analyses I turn to
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