Improved Forecasting of Mutual Fund Alphas and Betas

42 Pages Posted: 27 Jul 2005

See all articles by Matthew I. Spiegel

Matthew I. Spiegel

Yale University - Yale School of Management, International Center for Finance

Harry Mamaysky

Columbia University - Columbia Business School

Hong Zhang

Tsinghua University - PBC School of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: February 20, 2006

Abstract

This paper proposes a simple back testing procedure that is shown to dramatically improve a panel data model's ability to produce out of sample forecasts. Here the procedure is used to forecast mutual fund alphas. Using monthly data with an OLS model it has been difficult to consistently predict which portfolio managers will produce above market returns for their investors. This paper provides empirical evidence that sorting on the estimated alphas populates the top and bottom deciles not with the best and worst funds, but with those having the greatest estimation error. This problem can be attenuated by back testing the statistical model fund by fund. The back test used here requires a statistical model to exhibit some past predictive success for a particular fund before it is allowed to make predictions about that fund in the current period. Another estimation problem concerns the use of a single statistical model for all available mutual funds. Since mutual funds often, but not always, employ dynamic trading strategies their betas move over time in a ways that differ from fund to fund. Since no one statistical model is likely to fit every fund, the result is a great deal of misspecification error. This paper shows that the combined use of an OLS and Kalman filter model increases the number of funds with predictable out of sample alphas by about 60%. Overall, a strategy that uses very modest ex-ante filters to eliminate funds whose parameters likely derive primarily from estimation errors produces an out of sample risk adjusted return of over 4% per annum.

Keywords: Mutual fund performance, back test

JEL Classification: G12, G13

Suggested Citation

Spiegel, Matthew I. and Mamaysky, Harry and Zhang, Hong, Improved Forecasting of Mutual Fund Alphas and Betas (February 20, 2006). Yale ICF Working Paper No. 04-23; EFA 2005 Moscow Meetings. Available at SSRN: https://ssrn.com/abstract=567284

Matthew I. Spiegel (Contact Author)

Yale University - Yale School of Management, International Center for Finance ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
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203-432-6017 (Phone)
203-432-8931 (Fax)

HOME PAGE: http://som.yale.edu/~spiegel

Harry Mamaysky

Columbia University - Columbia Business School ( email )

3022 Broadway
New York, NY 10027
United States

Hong Zhang

Tsinghua University - PBC School of Finance ( email )

No. 43, Chengdu Road
Haidian District
Beijing 100083
China

HOME PAGE: http://eng.pbcsf.tsinghua.edu.cn/content/details167_7995_x.html

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