Rebalancing reduces risk
- Alan Lavine and Gail Liberman
Consider evaluating mutual fund managers based on more than the past performance figures of their funds, say a group of finance professors. The recent study, by professors Randolph Cohen, and Joshua Coval, both Harvard, and Lubos Pastor, of University of Chicago, suggests a more effective technique.They advise evaluating mutual fund managers by comparing how their stock holdings stack up against those of other fund managers.
The professors created formulas to measure the skill of a fund manager by considering his or her stock holdings and trades.
"A fund manager's ability to select outperforming stocks is judged by the extent to which his investment decisions resemble those of other successful managers," the study says. "One way to assess the similarity of the managers’ investment decisions is to compare the composition of (a fund's holdings)."
The authors, in their study, use the example of two managers who both have registered excellent past performance. One manager has a large stake in Intel. The other has a large position in Microsoft. The Intel stock is held more often by other funds with good past performance records. By contrast, managers with mediocre and poor track records hold Microsoft more often.
The researchers conclude that the decision by the manager who owns Intel is "shared by a higher caliber set of managers that have a superior ability to select stocks." Meanwhile the second manager, whose holdings match other managers with sub par performance, was merely lucky that he registered good returns.
The finance professors have some complex formulas to measure a mutual fund manager’s stock picking skill. In a nutshell, the average person can compare a fund’s holdings and recent changes to the current holdings of the best-managed mutual funds over at least the past decade. You must compare similar funds. For example, if you are considering investing in a large company stock fund that buys undervalued stocks, compare the fund's holdings and changes in holdings to the Davis New York Venture Fund. The fund has registered top ratings over a couple of decades.
The study, "Judging Fund Managers by the Company They Keep," is published on the Social Science Research Network website (http://:papers.ssrn.com).
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Alan Lavine and Gail Liberman are husband and wife columnist and authors of The Complete Idiot's Guide To Making Money With Mutual Funds, (Alpha Books).
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