Peer-based R-squared and Mutual Fund Performance

Abstract

Existing studies find that measures of the distinctiveness of equity mutual fund investments are no longer significantly associated with fund performance in recent periods. We propose a new measure of fund distinctiveness by using peer stocks as benchmarks for fund holdings. This new distinctiveness measure, PBR2, has power to predict fund performance during a long sample period going back to 1980s as well as during the more recent period. The results are robust to variations in fund performance measures and definition of stock peers. The analysis on fund flows shows that investors pay attention to the traditional fund distinctiveness measures, which affects fund performance via decreasing return to scale. However fund flows have not reacted correctly to PBR2. Our findings suggest that fund investment distinctiveness remains valid conceptually as a signal of stock selection ability, but the performance predictive power of distinctiveness measures additionally depend on investor reaction.

Keywords: Mutual Funds, Stock Peers, Regression R-squared, Performance Prediction

JEL Classification: G23