Andrew Detzel, assistant professor of finance at the University of Denver’s Daniels College of Business, says there are potentially rewarding alternatives to passive investment strategies – but the potential and the rewards vary by equity-market segment. The research “Differences in Short-Term Performance Persistence by Mutual Fund Equity Class” was recently published in the Banking and Finance Review. The study was co-authored by Larry Detzel, professor at California State University, San Marcos.
Conventional wisdom in investing has said that active fund managers typically underperform the market after fees, and therefore investors are widely advised to invest in low-fee passive funds. However, Detzel argues that skilled mutual fund managers who invest in market segments with higher levels of mispricing, such as small-cap stocks, are more likely to demonstrate persistence in superior performance than similarly skilled active managers investing in market segments with lower levels of mispricing. Detzel examined the performance persistence of mutual funds by equity class.
He found that in the corners of the market where there is relatively high mispricing, and therefore opportunity for fund managers to beat the market, past top-performers are likely to continue to perform well.
“While all classes exhibit persistence in relative performance, large cap classes, for example, exhibit no evidence of persistence in superior performance,” Detzel says. “In small value stocks, the class in which mispricing is to be greatest, we found the average top quintile fund in a ranking-quarter continues to earn a post-ranking quarter four-factor-model abnormal return of 4.08 percent per year. This figure remains virtually unchanged at 3.99 percent per year when estimated in a seven-factor model comprised of investable index factors, the practicable alternative for investors.”
In conclusion, Detzel’s results suggest that in constructing mutual fund portfolios, investors should consider past fund performance when choosing funds in these areas (Small-cap, and mid-cap value stocks), but ignore past performance and invest in passive (low-cost) funds in larger-cap stock segments.
Detzel holds a Ph.D. in finance from the University of Washington. He teaches Fixed Income and Investments in the Reiman School of Finance and researches the relationship between macroeconomic risks and expected returns on financial assets. His work has been published in Management Science and Banking and Finance Review.