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New Methodology for Mutual Fund Performance

Paper Session

Sunday, Jan. 8, 2017 3:15 PM – 5:15 PM

Sheraton Grand Chicago, Chicago Ballroom VI
Hosted By: American Finance Association
  • Chair: Martijn Cremers, University of Notre Dame

Rethinking Performance Evaluation

Campbell Harvey
,
Duke University
Yan Liu
,
Texas A&M University

Abstract

The standard equation-by-equation OLS that is routinely used in performance evaluation ignores information in the alpha population and leads to severely biased estimates for the alpha population. Recent research has proposed a new approach --- essentially rethinking performance evaluation. Our contribution is a framework that treats fund alphas as random effects. This allows us to make inference on the alpha population while controlling for various sources of estimation risk. At the individual fund level, our method pools information from the entire alpha distribution to make density forecasts for each fund's alpha. In simulations, we show that our method generates parameter estimates that universally dominate the OLS estimates, both at the population and at the individual fund level. We also show the advantage of our approach compared to recently proposed alternative methods. An out-of-sample forecasting exercise also shows that our method generates superior alpha forecasts.

Skewness Consequences of Seeking Alpha

Kerry Back
,
Rice University
Alan Crane
,
Rice University
Kevin Crotty
,
Rice University

Abstract

Mutual funds seek alpha, but residual coskewness is also an important performance attribute.
Alpha and residual coskewness relative to the market are negatively correlated in theory, so
funds may generate undesirable residual coskewness in the pursuit of alpha. Empirically,
the trade-off exists for mutual funds and is driven by both fund composition and actions
of managers. Sorting funds by proxies for active management generates positive alpha, but
also undesirable coskewness. Investment styles also carry skewness consequences, but only
partially explain the trade-off in funds. A minority of funds overcome the trade-off. Thus,
seeking alpha generally comes at a skewness cost.

Cash-Flow Timing Versus Discount-Rate Timing: A Decomposition of Mutual Fund Market-Timing Skills

Chunhua Lan
,
University of New South Wales
Russ Wermers
,
University of Maryland

Abstract

This paper decomposes the measurement of market timing skills into talents that exploit aggregate (1) cashflow news and (2) discount-rate news, the two components of market returns. This differentiation reveals that the average U.S. domestic equity mutual fund has economically and statistically significant timing skills of about 1.2% per year: cashflow timing contributes 2% per year in abnormal returns, while discount-rate timing generates -0.8% per year. Our timing metrics identify a subset of funds with superior timing abilities that persist. For example, funds in the best timing quintile (those having the highest sum of the two timing ability components) exhibit about 2.5% total market timing abnormal returns over the next year. Our findings suggest that the misspecification of market timing skills accounts for the failure of prior research to properly identify funds with timing abilities.
Discussant(s)
Laurant Barras
,
McGill University
Marcin Kacperczyk
,
Imperial College London
Stijn Van Nieuwerburgh
,
New York University
JEL Classifications
  • G1 - Asset Markets and Pricing