"Can Mutual Fund "Stars" Really Pick

Stocks? New Evidence form a Bootstrap

Analysis"

Critical Review


2

Can mutual fund managers pick stocks? Clearly, scholars have not been coming to
an agreement when it comes to the ability of portfolio managers to earn abnormal
returns (Grindblatt et al, 1989). Even more controversial is the question whether
those unusual returns are the effect of superior stock-picking skills or just
extraordinary luck. Kosowski et al (2006) in their journal article shed a new light
on this problematic issue and suggest that in fact we can observe evidence of
managerial skills even though it is only visible in a small group of mutual funds.
In the following essay I will attempt to argue that the aforementioned article is an
interesting, thorough piece of research. Yet, the material which seems to give us an
intuitive impression of guaranteed success for skilled managers is, in fact,
contrasting many previous researches in the field. This argument will be further
developed throughout this critical review, discussing in turn the literature,
methodology and concepts.
Brief Summary
As stated above Kosowski et al (2006)
1
investigate whether in practice mutual
funds' excess performance is dependent on luck or extraordinary skills of its
managers. Having recognized the persistence in the literature to measure
performance controlling for luck, hence eliminating possibility that luck can also
continue, they have decided to conduct a thorough examination of mutual fund
performance without imposing an ex-ante distribution. In other words their
research question assumed that mutual fund alphas do deviate significantly from
normality, then asked how many funds would we expect to exhibit high alphas due
to luck alone, to finally compare the estimates with actual data in the sample.

Figure 1. showing Number of Funds from the Original and Bootstrap Sample with Performance
Above A Certain Value and Cumulative Economic Value (Source: Kosowski et al, 2006).

1
regarded to as the Authors throughout this critical review

3

In order to arrive at the findings they examined the performance of U.S. domestic
equity mutual fund industry between 1975 - 2002 - which is, in fact, the biggest
sample of funds ever researched, very valuable for statistical purposes. The study
utilized a bootstrap statistical technique to deal with non-normal distribution of
mutual fund alphas, which are a result of heterogeneous risk-taking. The research
findings suggest that 9 funds were expected to exhibit an abnormal alpha above
10% per year compared to 29 funds observed within the sample as presented in
Figure 1. This result was a solid ground for them to statistically prove that in no
way are the abnormal returns a result of luck alone. The findings are beneficial for
the investors as they are now better informed with regards to the best source of
the biggest utility gain (active versus index funds) and it increases investors trust
into well performing mutual funds especially in the times of economic downfall
(Kaushik et al, 2013). Hence, the research question is useful in finding validity of
the efficiency market hypothesis in mutual fund industry and whether in fact
Samuelson (1989) was wrong believing that there are no strategies that would
assure abnormal returns in the securities markets.
Weaknesses
However, was the authors' assumption of persistence in alphas deviation justified?
For years casual evidence was supporting the efficiency market hypothesis
suggesting that active funds cannot provide higher returns than passive funds and
there are no strategies that would guarantee high returns (Jensen, 1968,
Samuelson, 1989). Then Malkiel (1995) by using risk adjusted rate of return, which
was a great improvement in the accuracy of the calculation, asked whether the
funds that did well in one period, continued to earn high returns in the following
one. He discovered only weak evidence that funds with better past performance do
better than funds with worse past performance. In fact, two years later Carhart
(1997) seemed to push the point further and concluded that persistence in excess
returns is very weak to non-existent and that much of this persistence results due
to expenses and transactions costs rather than gross investment returns - what
Kosowski et al do reveal in their article. Surprisingly, they consider this minor
persistence a sufficient basis for their assumption of definite abnormal returns for
some managers. It seems that this inconclusive relationship between high returns
in subsequent periods for the minority of manager are not strong enough to be
taken for granted even though such stock-picking stars as Peter Lynch and Warren
Buffett exist.
Contributions to Literature
Nevertheless, the Authors' approach is still an innovative one. Clearly, being
critical of the established literature, which has only investigated the persistence of
outcomes controlling for luck, they modeled the role of luck in funds performance
instead. Kosowski et al made here a very interesting observation, namely that
those models discount the possibility that luck can also be a continuing factor.

4

Additionally, they have made another contribution to the field of finance
somewhat contrasting the findings of Berk and Green (2004), who agreed that
skilled mutual fund managers with deviated alphas have decreasing returns to
scale in their skills. They believed that profitable managers attract new funds until
additional transaction costs decrease the abnormal alphas to zero. In their
research they did prove existence of skill being relevant for returns, however
shortly. Kosowski et al, on the other hand, claimed that the mean convergence
occurs very slowly. Lastly, as mentioned in the summary the authors found strong
evidence of superior performance among growth-oriented funds but not with
funds having other objectives, which became an inspiration to scholars for further
research (Chen et al, 2013).
Methodology
The methodology used seem to be yet another contribution to the field of finance.
The authors reconstructed Carhart's (1997) test of persistence through
bootstrapping, checking whether the estimated four factor alphas of star mutual
fund managers are a result of luck or to some extent due to skill. The bootstrap
technique is commonly used to ensure proper inference and had not been used in
that context before. It is important to note here that for proper inferences to be
present the following three assumptions must hold: no estimation error, funds
having similar risk and individual funds to exhibit normally distributed returns.
Kosowski et al noticed, however, that some of those assumptions might not hold
for mutual funds. As seen in Figure 2. the estimated results present non-normal
cross-sectional distribution. With several bootstrapping techniques applied to
monthly net returns, the authors assigned proper measures of accuracy to alpha
estimates therefore improving the inference in identifying funds with significant
skills (Angelidis et al, 2012). Through applying bootstrap analysis they controlled
for the expected idiosyncratic outcomes variation as presented by thinner tails in
Figure 2. In the end by reconstructing Carhart's methods Kosowski et al arrived at
quite different conclusions.
Figure 2. presenting estimated versus bootstrapped cross section of alpha t-statistics (Source:
Kosowski et al, 2006)

5

Developments in literature since
Undoubtedly, the article has introduced new methods and new hypothesis about
mutual fund performance. However, has it inspired scholars to further research?
In fact, it did. Following its publication Cuthbertson et al (2008) have released a
paper on UK mutual fund performance. Applying the same bootstrapping
technique into the UK mutual fund industry, they arrived at similar results, namely
that poorly performing funds have low returns due to "bad skill". However, it
seems that Kosowski's article has initiated a wave of more in depth questions as
well. Within the next 7 years a number of scholars have started posing questions
regarding the nature of the skills that managers possess, in particular, on style-
timing ability. Chen et al (2013) present findings showing that growth timing
explains at least 45% of the excess returns reported in the sample. Budiono (2009)
on the other hand investigated, using bootstrap methodology, all three timing
skills: market, size and growth to discover that style timers do exist and using them
minimizes estimation errors.
Cuthbertson (2012) elaborates on the skill performance by empirically showing
that skilled funds tend to be concentrated on the very right tail whereas the
unskilled funds tend to be distributed throughout the whole left tail of
performance distribution. Additionally, he builds on the idea of False Discovery
Rate and points out that Kosowski's approach could be improved by adjusting for
false discoveries. Barras (2010) is yet another scholar to develop the FDR, as well
as estimating the proportion of skilled, unskilled and zero alpha funds in the entire
population.
Conclusions
To conclude, Kosowski et al has attempted to answer the question "Can Mutual
Fund Stars Really Pick Stocks" and it appears to be a worthy endeavor. I find this
article a thorough piece of research that any finance-enthusiast should be inclined
to read, mostly for its innovative use of bootstrap technique that uncovered
contrasting results to the established literature. Simply through reconstructing the
method of Carhart (1997) Kosowski et al arrived at an entirely different conclusion,
seemingly more precise. In that way the article is a source of a wave of change in
the portfolio performance evaluation. In spite of not being convincing when it
comes to justification of underlying assumptions I still believe that through careful
statistical analysis the article presents valid conclusions that abolish to a certain
extent the efficient market hypothesis. Mutual fund stars can really pick stocks.


6

Bibliography
Angelidis, T., Giamouridis, D and Tessaromatis, N. (2012) "Revisiting Mutual Fund
Performance Evaluation", MPRA Paper No. 36644
Barras, L., Scaillet, O. and Wermers, R. (2010) "False Discoveries in Mutual Fund
Performance: Measuring Luck in Estimated Alphas", The Journal of Finance 65, pp.179-
216
Berk, J. and Green, R. (2004) "Mutual Fund Flows and Peformance in Rational Markets",
Journal of Political Economy 112, pp.1269-95
Budiono, D. and Martens, M. (2009) "Mutual Fund Style Timing Skills and Alpha",
Working paper, available at SSRN: http://ssrn.com/abstract= 1341740, 13.11.2013
Carhart, M. (1997) "On Persistance in Mutual Fund Performance", Journal of Finance 52,
pp.57-82
Chen, L., Adams, A. and Taffler, R. (2013) "What style-timing skills do mutual fund "stars"
possess", Journal of Empirical Finance 21, pp.156-173
Cuthbertson, K and Nitzsche, D. (2012) "False Discoveries in UK Mutual Fund
Performance", European Financial Management, Vol.18, No.3, pp.444-463
Cuthbertson, K., Nitzsche, D. and O'Suillivan, N. (2008) "UK mutual fund performance:
Skill or Luck?", Journal of Empirical Finance 15, pp. 613-634
Grinblatt, M., and Titman, S. (1989) Mutual Fund Performance: An Analysis of Quarterly
Portfolio Holdings. Journal of Business 62, pp. 393-416.
Jensen, M. (1968) "The Performance of Mutual Funds in the Period 1945-1964", Journal
of Finance 23, pp.389-416
Kaushik, A. (2013) "Performance and Persistence of Performance of Actively Managed
U.S. Funds that Invest in International Equity", The Journal of Investing 22, pp. 55-63
Kosowski, R., Timmermann, A., Wermers, R. and White, H. (2006) "Can Mutual Fund
"Stars" Really Pick Stocks? New Evidence from a Bootstrap Analysis", The Journal of
Finance 61, pp. 2551-2595
Malkiel, B (1995) "Returns from Investing in Equity Mutual Funds 1971-1991", Journal of
Finance 50, pp. 549-72
Samuelson, P. (1989) "The Judgement of Economic Science on Rational Portfolio
Management", Journal of Portfolio Management 16, pp. 4-12