Optionable Stocks and Mutual Fund Performance

• Date: 01 March 2018
• DOI: http://doi.org/10.1002/fut.21844
• Author: Kainan Wang,Doojin Ryu,Blerina Bela Zykaj,Chune Young Chung
• Published date: 01 March 2018

Optionable Stocks and Mutual

Fund Performance

Chune Young Chung, Doojin Ryu, Kainan Wang ,* and Blerina Bela Zykaj

We examine whether stock-level options information drives mutual fund performance. Our

paper is motivated by existing studies indicating that options prices or implied volatilities

predict stock returns. We find that stock-implied volatility innovations forecast mutual fund

performance. Specifically, mutual funds investing in fewer optionable stocks or optionable

stocks with favorable information outperform other funds. In addition, mutual fund managers

overall do not trade on past options information. However, well-performing fund managers use

that information to decrease their holdings in poorly performing stocks. Moreover, well-

performing mutual funds containing strong options information tend to increase their holdings

in optionable stocks in subsequent periods. © 2017 Wiley Periodicals, Inc. Jrl Fut Mark

38:390–412, 2018

1. INTRODUCTION

The existing literature suggests that information, at both the mutual fund and stock

levels, predicts mutual fund performance. Several mutual fund characteristics, such as

fund size, family size, active share, R

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, turnover, and expense ratio, are predictive of

future abnormal fund returns. Predicting mutual fund performance using stock-level

information is less explored in the literature. Early studies show that mutual funds earn

higher abnormal returns when the stocks they hold outperform their respective

benchmarks (Chen, Jegadeesh, & Wermers, 2000; Daniel, Grinblatt, Titman, &

Wermers, 1997; Pinnuck, 2003; Wermers, 2000). The few studies that examine mutual

fund performance predictions using stock-level information focus on corporate events.

For example, Cai and Lau (2015) find that stock trading by mutual fund managers around

stock earnings announcements explains the variation in mutual fund performance.

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Chune Young Chung is an assistant professor at the School of Business Administration, Chung-Ang

University, Seoul, Republic of Korea. Doojin Ryu is an associate professor at the College of Economics,

Sungkyunkwan University, Seoul, Republic of Korea. Kainan Wang is an assistant professor at the College of

Business and Innovation, University of Toledo, Toledo, Ohio. Blerina Bela Zykaj is an assistant professor at

the College of Business, Clemson University, Clemson, South Carolina. The authors are grateful for the

helpful comments and suggestions from Robert I. Webb (editor), Truong Duong, and seminar participants at

the 2016 Financial Management Association meetings.

JEL Classification: G11, G13

*Correspondence author, Department of Finance, College of Business and Innovation, University of Toledo,

Toledo, OH. Tel: þ419-530-4317, Fax: þ419-530-2873, e-mail: kainan.wang@utoledo.edu

Received August 2016; Accepted December 2016

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Cai and Lau (2015) follow Baker, Litov, Wachter, and Wurgler (2010) in their use of stock earning announcements

to assess mutual fund managers’stock-selection abilities. Specifically, they investigate whether mutual fund

managers place informed trades around stock earning announcements.

The Journal of Futures Markets, Vol. 38, No. 3, 390–412 (2018)

© 2017 Wiley Periodicals, Inc.

Published online 23 Feruary 2017 in Wiley Online Library (wileyonlinelibrary.com).

DOI: 10.1002/fut.21844

Fang and Kosowski (2007) find that mutual funds closely following star analysts’

recommendations outperform other mutual funds.

In this paper, we investigate whether mutual fund managers show selection skills for

stocks with options written on them (i.e., optionable stocks) and whether this stock

characteristic predicts future fund performance. Our paper is motivated by the large body of

literature that links underlying spot prices to the information content of options products

(Cao, Chen, & Griffin, 2005; Cremers & Weinbaum, 2010; Hsieh & He, 2014; Jin, Livnat, &

Zhang, 2012; Johnson & So, 2012; Ryu, 2011, 2015; Truong, 2012). One notable recent

study by An, Ang, Bali, and Cakici (2014) shows that option-implied volatilities contain

useful information for forecasting cross-sectional stock returns.

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They find that news arrival,

as measured by option volatility innovations, results in significant return spread over the next

month. In this study, we hypothesize that the stock-level options information is also useful in

forecasting mutual fund performance.

Usinga sample of U.S. equitymutual funds during1996–2011,weshowthatmutualfund

portfolioscomprise a significantproportion of optionablestocks. On average,41% of the stocks

heldby mutual fundsare optionable.Using these optionablestocks,we confirm the mainfinding

in An et al. (2014) that implied volatility innovations, espe cially the difference in put and call

implied volatility innovations, predict stock returns. More interestingly, non-optionable stocks

in the sample outperform optionable stocks, suggesting that a mutual fund’s performance

depends both on the implied volatility information of the optionable stocks in the fund’s

portfolioand on the fraction of optionable stocksin that portfolio. Theseresults provide a good

foundationto study the effectof stock-leveloptions signals onfuture mutual fundperformance.

Our results reveal a relationship between mutual fund demand and past options

information: mutualfunds that perform well decrease their holdingsin stocks with worsening

options information; and trading by poorly performing mutual funds is inversely related to

options signals.However, mutual funds in aggregate do notseem to trade on such information.

In addition, mutual funds tend to increase their exposure to optionable stocks after their

portfolio containsstrong options signals. We also examine the predictability of options signals

for mutual fund performance and find strong evidence that implied volatility innovations

explaincross-sectional fund returns.Mutual funds with fewer optionable stocksand those with

favorable stock-level options information significantly outperform other mutual funds. The

differences in mutual fund characteristics and styles do not explain this outperformance,

which persists for up to 6 months after the options information is revealed in the market.

Our study is related to studies e xamining the options trading b ehavior of mutual

funds (Almazan, Brown, Carl son, & Chapman, 2004; Cici & Palacios, 2015; Deli &

Varma, 2002; Koski & Pontiff , 1999). These studies generally find no significant d ifference

in performance between mutu al funds that use derivativ es and those that do not, casting

doubt on the options trading skills of mutual fund managers. Our findings support the no

skill hypothesis of mutual fund managers in terms of their aggregate trading activity. Our

study is also related to DeMiguel, Plya kha, Uppal, and Vilkov’s (2013) investigation of how

managers can use the informa tion implied by options pric es to improve portfolio selection.

They conclude that options p rices contain useful inform ation that improves the out -of-

sample performance of portf olios. Similarly, we find that th e mutual fund portfolio

composition with respect to optio nable and non-optionable stocks f oretells future fund

performance.

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In addition to explaining and forecasting the cross-sectional returns of underlying assets, the information content

and informational role of option-implied volatilities are well documented (Fernandes, Medeiros, & Scharth, 2014;

Frijns, Tallau, & Tourani-Rad, 2010; Giot, 2005a, 2005b; Han, Guo, Ryu, & Webb, 2012; Han, Kutan, & Ryu, 2015;

Kim & Ryu, 2015; Song, Ryu, & Webb, 2016).

Optionable Stocks and Mutual Fund Performance 391