Implied Cost of Capital and Mutual Fund Performance

Abstract

This study provides evidence for a positive association between mutual fund holdings' implied cost of capital (ICC) and future performance. Consistent with large transaction costs of ICC-based investments impeding their exploitation and employing a ICC-based strategy reflecting skill, family-level trading efficiency and manager-level SAT score positively correlate with fund-level ICC. A negative association between ICC and mid-year risk shifting corroborates the notion of fund managers decisively choosing and relying on high-ICC strategies. Institutional investors able to identify funds with high ICC direct their investments accordingly, whereas flows of retail funds are unaffected, consistent with limited investor attention and financial literacy.

Keywords: implied cost of capital, mutual funds, portfolio choice, financial forecasting

JEL Classification: G11, G14, G17, G23, G31, M41