One of the top 10 investing books that influenced my own investing views and biases is “What Works on Wall Street” by James O’Shaughnessy. What most attracted me to the book was the massive amount of data analysis the author goes through, and more importantly, that the author isolates fundamental factors which tend to persist through time. Similarly, discovering factors which work best in identifying superior money managers is of significant value in wealth management. In academia, this kind of research-based information has always been scarce, and what little there is has not always been useful. 


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Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. MainStay Investments does not guarantee their accuracy or completeness, nor does MainStay Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.

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To that point, in 2011, Dr. Russ Wermers co-authored a piece that sifted through a significant amount of academic research to isolate the factors of successful manager selection. I have found this piece to be a valuable reference for due diligence practitioners. In it, Dr. Wermers dives deep into relevant qualitative and quantitative factors that have shown statistical significance in factors that focus on past performance, holdings analysis, fund/manager characteristics, and macroeconomic forecasting. Key takeaways by category include:

  1. Past performance – Not surprisingly, according to Harlow and Brown (2006), persistence of performance is key, but only if excess returns are adjusted to account for style biases.  The authors documented that improved odds of success in finding an outperforming fund rose from 45% to 60%.  Similarly, Pastor and Stambaugh (2002) found success in adjusting for sector biases.  Kosowski, Timmermann, Wermers and White (2006) performed an examination to see if there was a way to discriminate between managers that are lucky versus those who show greater return persistence or positive skew.  They found increased odds of identifying funds with greater return persistence by adjusting for random skewness in performance for growth-oriented funds.  They found no evidence of ability of income-oriented funds.

  2. Holdings Analysis – Avoiding funds with large negative “return gaps” between publicly reported and holdings-derived performance turns out to be a good idea as managers with large gaps may indicate hiding poor trades or window dressing.  The research produced by Kacperczyk, Sialm, and Zheng (2008) showed an impact of 216 bps per year.  Similarly, in Huang, Sialm, and Zhang (2013), funds with higher volatility from “risk shifting” tended to underperform. Risk shifting was calculated as the difference in volatility between the published performance of a fund and its holdings-derived performance.  Then there is, of course, the highly debated Active Share metric by Cremers and Petajisto (2009).  See our previous quarterly edition for the latest findings of Dr. Cremers’ research.

  3. Fund/Manager Characteristics – Some of the more interesting findings on performance in this section showed that managers with a CFA designation have less tracking risk than fund managers without the chartership (Dincer, Gregory-Allen, and Shawky (2010)).  Eating one’s own cooking is also important as managers who invest in their own funds tend to perform better (DeSouza and Gokcan (2003)).  Studies that focus on the structure of the fund company are also relevant.  Funds that are sponsored by large management companies (e.g., MainStay Investments and MacKay Shields) tend to perform better than those sponsored by small companies due to economies of scale, greater resources and better technologies.  Along the same lines, flatter organizations tend to perform better than complex hierarchies do.   A number of studies have also shown that including a shorting program can improve a fund’s risk-adjusted performance.  Factors that appear to do well with a shorting program are momentum, value and accrual.  Two mutual funds that are reflective of this success are the five-star 130/30 U.S. and International funds subadvised by Cornerstone Capital Management (MYCIX* & MYIIX*). Some other relevant but less surprising findings related to access to social networks, specialization of industry or sectors and quality of education.

  4. Macroeconomic Forecasting – While many investment practitioners would agree that on average, active managers outperform in down markets, Kosowski (2006) actually went through the analysis by observing four-factor alphas during recession and expansion phases from 1963-2005 across various U.S. equity styles. In every style measured (growth, aggressive growth, growth & income and balanced & income), active managers outperformed in recessions and underperformed in expansions. 

In a separate study, Avramov and Wermers (2006) found significant outperformance in selecting U.S. funds, ex ante, by their prior correlations with macroeconomic factors that have shown to predict equity returns (i.e. short-term rates, credit default spread, term structure and dividend yield).  Subsequent research has shown this process extends to European equity and hedge funds.  The most significant challenge in implementing this style of analysis is that the turnover tends to be high, thus taxes and transaction costs will erode performance.

While the findings in these various papers are promising, they can never replace the value a due diligence analyst can bring to bear on funds.  If you and your team would like MainStay to arrange a call or meeting with Dr. Wermers to discuss his research further, please let us know.   

John Lloyd CFA, FRM, CAIA
Managing Director
T: 212-576-8107