Investing in Mutual Funds when Returns are Predictable

Abstract:     
This paper analyzes the performance of portfolio strategies that invest in no-load, open-end U.S. domestic equity mutual funds, incorporating predictability in (i) manager skills, (ii) fund risk-loadings, and (iii) benchmark returns. Predictability in manager skills is found to be the dominant source of investment profitability -- long-only strategies that incorporate such predictability considerably outperform prior-documented "hot-hands" and "smart-money" strategies, and generate positive and significant performance with respect to the Fama-French and momentum benchmarks. Specifically, these strategies outperform their benchmarks by 2-4% per year through their ability to time industries over the business cycle. Moreover, they choose individual funds that outperform their industry benchmarks to achieve an additional 3-6% per year. Overall, our findings indicate that industries are important in locating outperforming mutual funds, and that active management adds much more value than documented by prior studies.

Number of Pages in PDF File: 58

Keywords: Equity mutual fund, asset allocation, manager skills, business cycle

JEL Classification: G11, G12, C11

working papers series