Accrual Quality, Skill, and the Cross-Section of Mutual Fund Returns

71 Pages Posted: 10 Sep 2013 Last revised: 22 Nov 2016

See all articles by Suresh Nallareddy

Suresh Nallareddy

Duke University - Fuqua School of Business

Maria Ogneva

University of Southern California - Marshall School of Business

Date Written: June 1, 2015

Abstract

We use returns of actively managed mutual funds to document the link between accrual quality (AQ) and systematic (priced) risk. Despite compelling theoretical arguments, prior research finds no evidence that poor AQ commands a risk premium in the cross-section of realized stock returns. We argue that the previously obtained premium estimates are biased downward because, for a large portion of poor AQ stocks, higher expected returns are offset by the news of deteriorating fundamentals. We suggest that skilled mutual fund managers should be able to either avoid investing in stocks with deteriorating fundamentals or assign them lower portfolio weights. As a consequence, returns on their portfolios should better reflect the expected AQ risk premium. Our empirical evidence is consistent with these predictions. First, we document that mutual funds’ portfolios are indeed less exposed to deteriorating fundamentals than are the portfolios of randomly selected stocks with similar AQ. Second, we find that mutual fund returns reflect a significant premium associated with AQ: high-skill funds with worse AQ holdings earn significantly higher returns than funds with better AQ holdings. Additional results point to the risk-based explanation for a large portion of the identified AQ premium.

Keywords: Earnings quality, accruals, cost of capital, returns, mutual funds, skill

JEL Classification: M41, G11, G12, G23

Suggested Citation

Nallareddy, Suresh and Ogneva, Maria, Accrual Quality, Skill, and the Cross-Section of Mutual Fund Returns (June 1, 2015). Columbia Business School Research Paper No. 13-71. Available at SSRN: https://ssrn.com/abstract=2322986 or http://dx.doi.org/10.2139/ssrn.2322986

Suresh Nallareddy

Duke University - Fuqua School of Business ( email )

Box 90120
Durham, NC 27708-0120
United States

Maria Ogneva (Contact Author)

University of Southern California - Marshall School of Business ( email )

701 Exposition Blvd
Los Angeles, CA 90089
United States

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