How to Judge Mutual Fund Managers Research by Lubos Pástor
New research suggests that mutual fund managers are best
evaluated by looking at the company they keep.
"Suppose an individual chooses a mutual fund manager with
a stellar three-year history and invests all his retirement
money with that manager," says Lubos Pástor, an
assistant professor at the University of Chicago Graduate School
of Business. "It's not clear that the manager will perform
well in the future, and the investor may lose a large sum of
money. Figuring out which managers perform well is really a
$4 trillion question that the investment community wants to
Together with Randolph Cohen and Joshua Coval of Harvard Business
School, Pástor suggests a new approach to answering this
question in the study "Judging Fund Managers by the Company
When people compete, their success can often be predicted by
their techniques, and the track records of others who use the
Take a group of basketball players, some of whom shoot with
both hands and some with only one hand, who have been taking
ten shots each. So far two-handed shooters have on average made
eight out of ten shots, while one-handed shooters have made
four out of ten. Two players, one one-hander and one two-hander,
have completed only half of their shots, with both sinking four
out of five shots. Although the track records of
both players are identical, it seems sensible to forecast that
the two-handed shooter will achieve a higher score, because
previous scores have shown that two-handed shooters tend to
score higher. The one-handed shooter, using what appears to
be an inferior technique, is more likely to have just been lucky
in his first five shots.
Mutual fund managers also rely on a variety of techniques when
trying to outperform their peers, and many of these techniques
are common to groups of managers. They may, for example, collect
information from the same sources or use the same valuation
"Managers using similar techniques should be expected
to deliver similar future performance," argues Pástor.
Since managers' techniques are difficult to observe, the study
focuses directly on managers' investment decisions, which can
be observed from periodic portfolio disclosures. Managers using
similar techniques are likely to make similar investment decisions,
so a fund manager's ability to select outperforming stocks can
be judged by the extent to which his investment decisions resemble
those of other successful managers.
Traditional methods of judging mutual fund managers rely solely
on a manager's own historical returns, typically taking his
track record and then calculating average returns from that
track record. Since the return histories of many existing funds
are short, these textbook measures are often imprecise, and
it is difficult to separate skill from luck.
Pástor, Cohen, and Coval propose a new way of ranking
mutual fund managers that should predict performance more accurately.
Their new measures look at the returns of all managers whose
holdings or trades overlap with those of an individual manager.
The most significant detail is the individual manager's degree
of similarity with managers who have performed well, and difference
from those who have performed poorly. The authors' results indicate
that their new skill measures are approximately four to eight
times more precise than traditional return-based measures.
If two managers hold similar stocks or buy and sell the same
stocks at the same time, then they would be said to be following
similar techniques. For each stock at each quarter-end, the
authors calculate the average track record of all managers who
recently bought this stock and subtract the average track record
of all managers who recently sold this stock. The result is
referred to as "stock quality." The authors next define
a manager's skill as the average quality of all stocks that
the manager recently bought minus the average quality of all
stocks that he recently sold.
"In evaluating the performance of manager A, we take account
of manager A's historical track record, as well as the historical
track records of managers B and C," says Pástor.
"If manager A's investment decisions are more similar to
manager B's than manager C's, we pay more attention to manager
B's track record than to manager C's track record in judging
Are these new measures useful in evaluating true managerial
skill? Using simulated data, the authors find that the answer
is yes. Their measures prove to be increasingly accurate as
the number of managers increases.
Pástor, Cohen, and Coval also analyzed the performance
of a large sample of U.S. equity funds. For all 3,281 funds
that had existed for two or more years at the end of their sample
(September 30, 2000), they estimated all performance measures
and their precision using the complete return history for each
fund. The authors find that their new system is more precise
than the traditional measure for over 90 percent of all funds.
This result is not surprising because a typical fund holds
dozens of stocks, and a typical stock is held by dozens of funds.
Each additional holder improves the precision of the new estimate
of stock quality, and each additional stock makes this fund
performance estimate more precise.
More Positive Than Expected
According to these new measures, are there mutual fund managers
who demonstrate true skill?
Using traditional returns-based measures of performance, one
would find as many bad managers as good managers (even before
accounting for transaction costs and fees charged to investors).
Good managers, with "positive skill," are defined
as those who can beat their passive benchmarks. Bad managers,
with "negative skill," are those who underperform
their passive benchmarks.
Pástor argues that those results do not make much sense.
"For a rating system to judge a manager's skill to be
negative would require the manager to be less skilled than a
monkey managing a portfolio by throwing darts," says Pástor.
"Our results are more plausible, because we find that there
are quite a few managers who are able to beat their benchmarks
before costs and fees, but very few who can't."
According to the study, fund managers with significantly positive
skill before costs and fees vastly outnumber fund managers with
significantly negative skill. The authors find only three funds
in their sample that show significantly negative skill, while
1,076 funds show significantly positive skill.
Nonetheless, managers' superior skill does not necessarily
persist over time. Mutual fund returns remain almost unpredictable,
as should be expected in a competitive market.
Lubos Pástor is assistant professor of finance at
the University of Chicago Graduate School of Business.