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Yes, Mutual Fund Managers Do Have Skill

A fat lot of good that does them.

John Rekenthaler, 07/11/2017

Hopes and Prayers
A Bloomberg editor alerted me to an academic paper that takes a new angle on measuring investment-manager skill. Rather than compare an entire fund's performance to that of a benchmark, Roberto Stein in "Are mutual fund managers good gamblers?" looked only at a sliver of stock-fund portfolios. Within that sliver, he found, professional mutual fund managers are highly successful.

To explain: Following a 

shiller/behfin/2005-04/kumar.pdf" target="_blank">predecessor's lead, Stein identified a subgroup of the U.S. equity markets that he terms "lottery stocks." Such issues are those with relatively low stock prices, high idiosyncratic risk, and high idiosyncratic skewness. In plainer English, those stocks are the investment version of lottery tickets, because they don't cost much and have a potentially high payoff. They behave very differently from the overall market, and extremely at that.

If everyday Americans will plunk down $1 for a lottery ticket that carries an expected return of 50 cents, then perhaps they also will overpay for lottery stocks. That is in fact what appears to happen. Although individual investors directly own only a small portion of the stock market, they are the majority owners of lottery stocks. And those issues perform brutally badly. For the 24-year period 1980-2013, Stein found that lottery stocks trail the rest of the market by an average of 9 percentage points per year.

While that shortfall is not this column's main topic--which, after all, is about manager skill--it deserves discussion. It is quite remarkable that three straightforward statistical tests can locate a large number of securities that, in aggregate, behave so poorly. Yes, the tests were designed after the fact, raising the possibility (nay, probability) that academic researchers have mined data to come up with something publishable. Still, the lottery definition isn't that far-fetched, and the results are extreme indeed.

Answer Me These Questions Three
That led me to pondering. First, can an equally straightforward search identify stocks that beat the market by 9 percentage points per year?  I think that unlikely; otherwise, we would be bombarded with exchange-traded funds that follow such a strategy.

Second, are mutual fund managers aware of this anomaly? I suspect not. Clearly, they find this type of stock to be unattractive, as they have largely ceded ownership to individual investors. But most portfolio managers don't think systematically about such things; they don't avoid lottery stocks because they believe that there is such a category and that individual buyers have overpaid for the group. Rather, they buy investments that look attractive--and most of the lottery stocks do not.

Third, is somebody profiting from this great collective mistake? You got me. Indirectly, any professional investor with an underweighting in these stocks benefits from the decision. However, as these companies are large in number but small in market capitalization, that doesn't have much effect on portfolio performance. The real way to gain from the Lottery Stock Effect is to short those securities en masse. If anybody is doing that, I am unaware. Certainly, no mutual fund is.

is vice president of research for Morningstar.

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