Fund forecasting

abnormalreturns
March 23rd, 2006

The concept of mutual fund return forecasting gets short shrift in general. The financial press spends the vast majority of their energy on individual stocks and the “stories” that drive their returns. Our guess is that this is simply “sexier” than discussing mutual funds. This is in spite of the fact that individuals hold the bulk of their investment assets in mutual funds, especially when discussing retirement accounts.

Two items came to our attention that provide investors a way to measure (and forecast) the future performance of mutual funds. One is relatively new and unknown, the other is well-established and widely known.

Arden Dale in the Wall Street Journal highlights some research by a trio of academics that lays out a new way to measure manager skill. The so-called “return gap” attempts to measure those unseen actions by managers in between the snapshots of the fund at quarter and year-end.

Based on an analysis of monthly return data for more than 2,500 U.S. equity funds, the study covers the period from 1984 to 2003. It hinges on the notion of a return gap, which is the difference between a fund’s current returns to investors and returns on a “holdings portfolio,” which is the same fund’s previously disclosed holdings, usually reported several months before. In calculating the return gap, the method subtracts expenses from the holdings portfolio.

“Many mutual-fund studies use holdings data to analyze the performance and strategies of mutual funds,” wrote the study authors. “We show that a large amount of information is lost by only considering the holdings. The return gap between investor and holdings return is persistent and helps predict future performance.”

The WSJ article does a good job of explaining the concept. One attractive feature is that it moves beyond the somewhat static notion of return analysis. One can find the entire paper here.

Despite Morningstar’s popularity as a pioneer in the area of mutual fund analysis, their star system has always been a target. CXO Advisory recaps another paper that studies the Morningstar star system and finds there is more there than meets the eye. A recent academic paper finds the overhauled Morningstar rating system is able to discern future relative fund performance. The fund only covers a short period of time the results are heartening nonetheless.

Despite the push from exchange traded funds, traditional open-end mutual funds are not going anywhere any time soon. For investors who are currently focusing on relative strength or momentum-based systems to pick mutual funds it is good to know that there are alternatives available.