TAILIEUCHUNG - Investigating Underperformance by Mutual Fund Portfolios

We consider two types of dogmatists. The first is a ‘‘no-predictability dogmatist (ND),’’ who rules out predictability, additionally setting the parameters bi1 and Af in Eqs. (1) and (2) equal to zero. The second is a ‘‘predictability dogmatist (PD),’’ who believes that mutual fund returns are predictable based on observable business cycle variables. We further partition our PD investor into two types: PD-1, who believes that fund risk loadings are predictable (., bi1 is potentially nonzero), and PD-2, who believes that both risk loadings and benchmark returns are predictable (., bi1 and Af are both allowed to be nonzero). Note that our PD investors believe that asset. | Investigating Underperformance by Mutual Fund Portfolios By Theodore E. Day Yi Wang Yexiao Xu School of Management The University of Texas at Dallas This version May 2001 Abstract Underperformance by equity mutual funds has been widely documented by both the popular press and academic research. Whereas previous research has interpreted underperformance as evidence that fund managers lack the ability to pick stocks this paper focuses on the impact of portfolio composition and excess turnover on fund performance. Using standard portfolio optimization techniques we show that the portfolio weights for the stocks selected by fund managers are on average inefficient. Our results suggest that while fund managers may actually possess superior stock selection skills substantial gains could be achieved by improving the efficiency of the allocation of mutual fund assets. In addition we present evidence suggesting that mutual fund turnover is excessive and that fund managers may rely too heavily on stock price momentum. We are grateful to Wayne Ferson Richard Green Burton G. Malkiel Larry Merville and the anonymous referees for their comments. The address of the corresponding author is Yexiao Xu School Of Management The University of Texas at Dallas PO Box 688 Richardson Texas 75080 USA Email yexiaoxu@ i Investigating Underperformance by Mutual Fund Portfolios Abstract Underperformance by equity mutual funds has been widely documented by both the popular press and academic research. Whereas previous research has interpreted underperformance as evidence that fund managers lack the ability to pick stocks this paper focuses on the impact of portfolio composition and excess turnover on fund performance. Using standard portfolio optimization techniques we show that the portfolio weights for the stocks selected by fund managers are on average inefficient. Our results suggest that while fund managers may actually possess superior stock selection skills substantial gains .

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