The Information Content of Aggregate Mutual Fund Alpha

Abstract

Recent evidence shows that mutual funds collectively buy overvalued stocks. I hypothesize that aggregate mutual fund alpha partly arises from such stocks becoming even more overvalued and thus is a measure of market overvaluation. A one-standard-deviation increase in aggregate alpha corresponds to a 0.63 percentage-point decrease in the following month’s market return, and aggregate alpha yields a monthly out-of-sample R-squared of 2.79%. The predictability indeed stems from funds tilting toward overvalued stocks and small-cap or growth styles. Further consistent with overvaluation, higher aggregate alpha predicts higher anomaly returns and lower earnings surprises. The evidence is difficult to reconcile with rational explanations based on benchmarking, flow, or catering. My findings highlight a novel common component of time-varying fund performance and a new empirical fact about the usefulness of abnormal fund returns for understanding expected stock returns.

Keywords: alpha, mutual funds, information content, predictability, mispricing, behavioral finance

JEL Classification: G12, G14, G17, G23