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Rekenthaler Report

Yes, Mutual Fund Managers Do Have Skill

A fat lot of good that does them.

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 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.

(A few years ago, 130/30 funds were all the rage. Those funds invested 130% of their assets in stocks and then established 30% short positions. This tactic gave the funds 100% net stock positions, the same as with traditional equity funds, but with the ability to profit by identifying overvalued securities. Sadly, none of those funds did so. They pretty much all shorted blue chips, with a notable lack of success, rather than the obscure lottery stocks that truly were overvalued. Opportunity missed.)

Shining Stars
Now, the main point: According to Stein's research, although mutual fund managers don't always invest in lottery stocks, when they do, they are the World's Most Interesting Investors. As we have seen, lottery stocks overall perform terribly: 9 percentage points per year worse than other stocks. Have you ever heard of a portfolio manager so skilled that he could add 9 points per year through security selection? Me neither. Yet fund managers have easily accomplished this with lottery stocks.

Indeed, writes Stein, when mutual funds own lottery stocks, those securities not only overcome their huge headwinds, but actually outgain the rest of the stocks in the managers' portfolios. Mutual fund managers select lottery stocks so well that they turn that sector from being the single worst in the overall market to among the very best in their funds. Stein estimates that a portfolio formed by going long in lottery stocks that were held by mutual fund managers and short in those that were not would have grown more than 25% annually during the study period. (And if you know of a strategy that gains 25% per year on a portfolio that has no net stock exposure, do let me know.)

Many questions can be asked of Stein's finding. There are various devils in the study's details: How survivorship is addressed, assumptions made on the performances for stocks that are traded between reporting periods, whether equal- weighting the results (where very tiny funds can have a powerful effect) is sensible, or whether they should be asset-weighted. It is possible that a few methodological changes could dramatically cut fund managers' victory margin.

However, no matter how much trimming is done, it's hard to avoid Stein's conclusion that, within this particular market subsection, mutual fund managers have handsomely earned their keep. When selecting among the least-known, least-researched companies in the U.S. stock market, professionally trained managers have been overwhelmingly better than the typical individual investor. The pros drank the amateurs' milkshake.

From Theory to Practice
None of this has been of much help to fund investors. If the financial markets consisted of professionally managed funds controlling a small chunk of assets, and the least rational, most aggressive of individual investors were holding the lion's share, then active funds would rout the indexes. Passive investing would be a mistake. But such is not the case. Almost everywhere but with the lottery stocks, the pros control most of the money. When they trade, it is mostly with other professionals. Their skill is neutralized.

So, while it is encouraging to learn that active investment managers possess skill, that doesn't do fund investors more than theoretical good. Currently, too many pros chase too few opportunities. Ironically, the best hope that the professionals have is for the continued success of indexing strategies. Should enough active managers be chased out of the business, such that the rest of the stock market begins to resemble the lottery-stock segment, then the professionals could thrive. Until then, though, their lottery-stock success is merely a tease--a hint of what might be, were circumstances different.


John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.