When Opportunity Knocks: Cross-Sectional Return Dispersion and Active Fund Performance
Critical Finance Review, Forthcoming
58 Pages Posted: 11 Aug 2013 Last revised: 16 Nov 2015
Date Written: September 14, 2015
Active opportunity in the market, measured by cross-sectional dispersion in stock returns, significantly influences fund performance. Active strategies have the greatest impact on returns during periods of high dispersion, when alpha produced by the most active funds significantly exceeds that produced in other months. The outperformance of the most relative to the least active funds is also concentrated in months of high dispersion. Deciding when to invest in active funds, therefore, can be as important to generating outperformance as deciding which funds to invest in. Switching between highly active and passive funds based on dispersion produces significant alpha of over 2.7% p.a. after fees. This paper adds a new dimension to understanding how active funds can be used to generate value, by combining identification of which managers have the greatest potential to outperform the market with insight into when the market is most conducive to outperformance.
Keywords: Mutual funds, return dispersion, active management
JEL Classification: G11, G14, G20, G23
Suggested Citation: Suggested Citation