When is Stock-Picking Likely to be Successful? Evidence from Mutual Funds

Abstract

Consistent with a costly arbitrage equilibrium in which arbitrage costs insulate mispricing, this study finds that mutual fund managers have stock-picking ability for stocks with high idiosyncratic volatility but not for stocks with low idiosyncratic volatility. These findings suggest that fund managers and other investors may want to pay special attention to high-idiosyncratic-volatility stocks because they provide fertile ground for stock picking. The study also finds that the stock-picking ability of the average mutual fund manager declined after the extreme growth in the number of both mutual funds and hedge funds in the late 1990s.

Keywords: mutual funds, insitutional investors, arbitage, limits of arbitrage, idiosyncratic risk, market efficiency

JEL Classification: G11, G14, G20, G23, G29