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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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:
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
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.
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.
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
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