Investing in mutual funds: exploiting the cross-sectional predictability in fund performance

Abstract

This paper investigates the economic value generated by active mutual funds from an investor's perspective. We employ a utility-based portfolio approach to construct an investment strategy for U.S. active equity funds. The strategy jointly exploits the information conveyed by multiple fund characteristics and by macroeconomic indicators about the subsequent cross-section of fund performance. Based on an out-of-sample performance evaluation, we find that the proposed strategy consistently outperforms: (i) commonly used passive benchmarks; (ii) active strategies that exploit the fund characteristics on an individual basis; (iii) active strategies that exploit fund characteristics but without relying on the principles of portfolio theory. The outperformance is net of fees and expenses and after precluding short-sales and leverage. The fund specific information appears to have a substantially larger impact on portfolio performance than the macroeconomic information. We further show that the proposed strategy's superior performance originates mainly during periods of high market volatility relatively to calmer times. The findings indicate that investing in active equity mutual funds can add significant economic value for investors if the time-varying predictability in fund relative performance is properly taken into account and if an optimal portfolio approach, as opposed to simpler strategies based on sorting or on equal-weighted schemes, is adopted.