Aurora Borealis
1 November 2013 CFA Institute Journal Review

Time-Varying Fund Manager Skill (Digest Summary)

  1. Nicholas J. Handley

US mutual funds time the market more successfully during recessions than during economic expansions, but they pick stocks better during expansions. The same set of managers are able to perform both tasks well at different points in the economic cycle. The authors construct a new fund-level ex ante skill index that is conditioned on the state of the economy. They demonstrate its predictive power for performance and show that when using this metric, funds display persistent scores.

What’s Inside?

Because investors are increasingly outsourcing their decision making to professionals, the literature’s consensus that only the best funds are good stock pickers and few, if any, can time the markets is a concern. The authors’ nuanced approach, which involves conditioning stock-picking and market-timing performance on the health of the economy, is more reassuring. They explore whether the same managers excel during both booms and recessions or whether they specialize. A new index of ex ante manager skill is presented that is based on cyclical dynamic weightings to ex post stock picking and market-timing ability.

How Is This Research Useful to Practitioners?

US funds’ market-timing and stock-picking returns are regressed against a recession dummy variable with fund-specific control variables. Market timing yields 14 bps per month more in recessions than expansions, and stock picking outperforms in expansions by the same margin. Managers time the market best when macro factors dominate and pick stocks best in more benign environments. Re-running the regressions on fund subsets that are sorted according to their timing and picking ability reveals that the 95th percentile of market timers is 25 bps per month more successful in recessions, compared with just 6 bps for the median market timer. The analogous regression for stock pickers reveals that the best pickers are twice as sensitive to economic conditions as the median pickers. Market conditions matter more for skilled managers because only a subset are skilled.

Furthermore, top quartile stock-picking funds in expansions are 3.7 bps per month better at timing in recessions and equivalently for the expansionary stock-picking ability of top-performing market timers in recessions (i.e., the same managers outperform throughout the cycle) but by differing means. Market timing is achieved through variations of cash levels and also by stock beta rotation within the portfolio. The preceding results are applicable equally at the fund and manager level.

The authors engineer a skill index that dynamically weights timing and picking ability according to economic conditions. The timing weight is the probability of being in a recession, and the picking weight is the complementary probability. Funds in the top quintile of this skill measure subsequently outperform by 300–600 bps a year according to the capital asset pricing model and Fama–French three- and four-factor alphas. The persistence of funds in the top skill quintile lasts for up to six months, whereas timing and picking individually show no such persistence, which further demonstrates that skilled funds dynamically switch strategies according to market conditions.

How Did the Authors Conduct This Research?

Fund characteristics data are from the CRSP Survivor-Bias-Free Mutual Fund Database, stock holdings data are from Thomson Reuters, stock returns and fundamentals are from CRSP/Compustat, and recessions are defined according to NBER. Index and sector funds and those holding less than 80% in equities are excluded, which yields 3,477 funds and 250,219 observations from January 1980 to December 2005. The authors define two measures of ex post performance. Timing is defined as excess returns from having systematic (beta) exposure that differs from the market’s. Picking is defined as the beta-adjusted excess returns of the active positions.

NBER’s recession definition is precise but known only after the fact. The authors also consider recessions defined by RecRT, Chauvet and Piger’s real-time recession indicator (Journal of Business and Economic Statistics 2008), and by RecCFNAI, the inverse of the Chicago Federal Reserve’s National Activity Index. The authors’ main conclusions are robust to the recession definition choice.

Characteristic-wise, top-quintile funds are five years younger, are $400 million smaller, charge higher fees, and are more aggressive in terms of turnover, portfolio size, and beta deviation than their peers.

The authors consider possible alternative explanations for their results. Fund and manager composition changes and fund size changes are excluded by including fixed effects in the regressions. Stock price patterns are considered unlikely to be able to produce the observed results after the simulation of various strategies on 500 artificial stock returns. Finally, career concerns might be greatest in a recession. Market timing is something all managers could do well simultaneously, which implies herding behavior. But less herding is actually seen during recessions, ruling out this explanation.

Abstractor’s Viewpoint

The authors’ main finding that funds time the market well in recessions and pick stocks well during expansions is multifaceted. Academically, their finding better characterizes fund performance, and practically, it may help managers focus their energies more effectively. It also provides some evidence on the value of active mutual funds. The authors’ skill index is a useful tool that could benefit fund-of-funds managers or anybody timing their active managers. It would be worthwhile to extend the study period beyond December 2005 to incorporate the financial crisis and to encompass periods of enormous stock-picking return variation, such as the August 2007 “Quant Quake,” as well as the later abundant market-timing opportunities.

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