Co-authors:Mark Grinblatt, UCLA; Sheridan Titman, Boston College School of Management; Russ Wermers, University of Colorado, Boulder.
Status: Published, Journal of Finance, July 1997
Currently, over one trillion dollars are invested in actively managed equity mutual funds. These funds generate in excess of $10 billion in fees and expenses per year. This paper examines whether managers of these funds can systematically pick stocks that allow them to earn back a significant fraction of these fees and expenses. We investigate this issue by developing and applying new measures of portfolio performance that use benchmarks based on the characteristics of stocks held by the portfolios that are evaluated. Specifically, we construct 125 benchmark portfolios that are matched to the stocks held in the evaluated portfolio on the basis of the market capitalization, book-to-market, and prior-year return characteristics of those stocks. Based on these benchmarks, we develop ``Characteristic Timing" and ``Characteristic Selectivity" measures. These measures determine, respectively, whether portfolio managers successfully time their portfolio weightings on these characteristics (e.g., buying high book-to-market stocks when those stocks have unusually high returns) and whether managers can select stocks that outperform the average stock having the same characteristics. We apply these measures to a new database of mutual fund holdings covering over 2,500 equity funds from 1975 to 1994. Our results show that mutual funds, particularly aggressive-growth funds, exhibit some selectivity ability, but that funds have no characteristic timing ability. Thus, the average mutual fund beats a simple, mechanical strategy of choosing random stocks with the same characteristics as the stocks in the fund portfolio. The average fund outperforms the simple strategy by less than 100 basis points per year, which is approximately equal to the average management fee. Although aggressive-growth funds generate higher performance levels, they also generate higher fees and expenses. Thus, our results suggest that active mutual funds, as a group, outperform simple, mechanical strategies by enough to recover at least part of their fees and expenses.
Click here to view/print the paper (310 K)
Click here to view/print the unpublished appendix with data on the benchmark portfolios (160 K)
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