Is Timing Everything? The Value of Mutual Fund Manager Trades

• Date: 01 June 2013
• Author: Jon A. Fulkerson
• Published date: 01 June 2013
• DOI: http://doi.org/10.1111/fima.12005

Is Timing Everything? The Value

of Mutual Fund Manager Trades

Jon A. Fulkerson

I develop new measures of the value of active mutual fund management using portfolio holdings.

These measures simultaneously test for trading and selection skill within stocks, industries, and

characteristics. I demonstrate that most of the skill documented in prior studies comes from

correctly trading stocks within industries, though funds also have some skill in timing industries.

However, prior research focuses on the period 1980-1994. I also test the hold out sample 1995-

2007. Contrary to prior results, the latter period (and the full sample) demonstrates that mutual

funds generate no excess returns fromany category of skill.

The mutual fund literature examining the trading behavior of mutual funds documents skill in

gross returns (Chen, Jegadeesh, and Wermers, 2000). Mutual fund buys outperform sells, and

gross returns demonstrate positive excess returns. Therefore, fund managers are viewed as having

some stock trading ability prior to expenses. What is less clear is the source of manager skill.

I contribute to the literature on mutual fund performance by simultaneously testing for skill in a

united framework of performance measures that control for both selection and trading ability. My

measures decompose returns into two broad components. The trading component measures the

additional return gained or lost through changing the portfolio and captures the value created by

the short run anticipation of returns. The selection component measures how long-term holdings

would have created value. A manager with selection ability creates value by tending to hold

stocks that outperform over a longer period. The selection and trading components are not

mutually exclusive and a fund may benefit from both.

My measures also test for multiple sources of skill within the trading and selection components.

Prior research confirms skill in areas as diverse as market timing, anticipating individual stock

news, and industry selection, but few studies control for multiple sources simultaneously. For

example, Daniel et al. (1997) only test for trading skill in broad characteristics, while Kacperczyk,

Sialm, and Zheng (2005) only allow for timing in industries. Chen et al. (2000) test for individual

stock timing for the whole industry, but do not control for other forms of timing. In contrast, my

measures allow researchers to isolate selection and trading skill in all three areas: 1) individual

stocks, 2) industries, and 3) characteristic styles.

I apply these measures to mutual fund holdings from 1980 to 2007. I confirm that mutual funds

demonstrate little trading ability with respect to individual stocks, industries, or characteristics.

The funds do show some economically large stock selection ability, though most specifications

do not reach conventional levels of statistical significance. Stock selection skill within industries

is present from 1980 to 2007, but the measures are noisy and sensitive to timeframe. I conclude

I am grateful for comments from Bradford D. Jordan,Jason Smith, Yuehua Tang, seminar participants at the 2011 EFA

and FMA annual meetings, and an anonymous referee.

Jon A. Fulkerson is an Assistant Professorof Finance at Loyola University Maryland in Baltimore, MD.

Financial Management •Summer 2013 •pages 243 - 261

244 Financial Management rSummer 2013

that industry expertise provides, at best, only modest benefits to the average mutual fund overthe

full sample.

My second contribution to the literature stems from the prior finding that excess returns can

be attributed, in part, to timeframe. Daniel et al. (1997) find economically and statistically large

excess returns for the shorter period of 1975-1994. I confirm that mutual funds generated excess

returns over a similar period and that these excessretur ns come from stock trading (as suggested in

Chen et al., 2000). The following thirteen years (1995-2007), however, indicate small losses from

trading. Looking at the overall timeframe (1980-2007), the gains from trading are inconsistent

through time and close to zero, on average.

My finding of small gains from industry expertise differs from Kacperczyk, Sialm, and Zheng

(2005). Kacperczyk et al. (2005) find that funds with higher industry concentrations have higher

excess returns and suggest that industry expertise may generate value. I find that trading within

an industry generated large gains over the period analyzed by Kacperczyk et al., (2005), but

the same trading generated small losses in more recent years and almost zero return for the full

sample. Industry expertise over the full sample provided only minor benefits.

For robustness, I test the sensitivity of my results to portfolio construction. Mutual funds only

report holdings quarterly and I may be using stale positions to calculate trading skill. I recalculate

each measure assuming managers acquire the reported positions one to three months prior to

the report date. Like Nicolosi (2009), I find that excess returns increase when the manager

is assumed to have traded sooner. These higher excess returns are reflected in higher trading

skill, while selection skill stays mostly constant. Though suggestive,fur ther research with higher

frequency data would be necessary to confirm that the current methods underestimate manager

skill.

The remainder of this study proceeds as follows. The next section reviews previous studies of

fund manager performance and timing. Section II describes the new measures implemented in

this study and the sample on which the measures are applied. Section III presents the empirical

results, while Section IV provides some tests of robustness. Section V providesmy conclusions.

I. Background

Mutual fund holdings may be studied for insight into how mutual fund managers add (or

subtract) value through active management. Skilled active managers should buy stocks that

appreciate and sell stocks before they perform poorly.Consistent with this, some studies f ind that

stocks sold by mutual funds do poorly in the period after selling and those purchased provide

moderate positive returns (Chen et al., 2000; Pinnuck, 2003; Nicolosi, 2009). This evidence

suggests that fund managers create value through trading.

Similarly, a fund manager may have the ability to select industries. Funds concentrating in

fewer industries perform better than diversified funds, perhaps because the portfolio manager

has expertise in a set of industries (Kacperczyk et al., 2005; Avramov and Wermers, 2006; Busse

and Tong, 2012). Busse and Tong (2012) attribute around one-third of observed excess returns to

industry selection by fund managers.

Holdings are also used to study fund manager timing abilities. Studies generally focus on one of

three different aspects of timing. The first approach recognizes that a mutual fund’srisk level may

be time varying if the manager has an ability to anticipate market movements. Such a manager

would increase beta exposure in an up market and decrease exposure in a down market. The

evidence suggests small, but statistically significant differences in beta and, as such, at least some

degree of market timing ability (Bollen and Busse, 2001; Chance and Hemler, 2001; Jiang, Yao,