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Improved Forecasting of Mutual Fund Alphas and Betas

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  • Matthew Spiegel
  • Harry Mamaysky
  • Hong Zhang
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    Abstract

    This paper proposes a simple back testing procedure that is shown to dramatically improve a panel data model's ability to produce out of sample forecasts. Here the procedure is used to forecast mutual fund alphas. Using monthly data with an OLS model it has been difficult to consistently predict which portfolio managers will produce above market returns for their investors. This paper provides empirical evidence that sorting on the estimated alphas populates the top and bottom deciles not with the best and worst funds, but with those having the greatest estimation error. This problem can be attenuated by back testing the statistical model fund by fund. The back test used here requires a statistical model to exhibit some past predictive success for a particular fund before it is allowed to make predictions about that fund in the current period. Another estimation problem concerns the use of a single statistical model for all available mutual funds. Since mutual funds often, but not always, employ dynamic trading strategies their betas move over time in a ways that differ from fund to fund. Since no one statistical model is likely to fit every fund, the result is a great deal of misspecification error. This paper shows that the combined use of an OLS and Kalman filter model increases the number of funds with predictable out of sample alphas by about 60%. Overall, a strategy that uses very modest ex-ante filters to eliminate funds whose parameters likely derive primarily from estimation errors produces an out of sample risk adjusted return of over 4% per annum.

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    File URL: http://icfpub.som.yale.edu/publications/2361
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    Bibliographic Info

    Paper provided by Yale School of Management in its series Yale School of Management Working Papers with number amz2361.

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    Date of creation: 01 Jul 2005
    Date of revision: 01 Mar 2006
    Handle: RePEc:ysm:somwrk:amz2361

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    Web page: http://icf.som.yale.edu/
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    Keywords: Mutual fund performance; back test;

    References

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    1. Jonathan B. Berk & Richard C. Green, 2002. "Mutual Fund Flows and Performance in Rational Markets," NBER Working Papers 9275, National Bureau of Economic Research, Inc.
    2. Ferson, Wayne E & Harvey, Campbell R, 1991. "The Variation of Economic Risk Premiums," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 385-415, April.
    3. Goetzmann, William N. & Ivković, Zoran & Rouwenhorst, K. Geert, 2001. "Day Trading International Mutual Funds: Evidence and Policy Solutions," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 36(03), pages 287-309, September.
    4. Ivo Welch & Amit Goyal, 2008. "A Comprehensive Look at The Empirical Performance of Equity Premium Prediction," Review of Financial Studies, Society for Financial Studies, vol. 21(4), pages 1455-1508, July.
    5. Bossaerts, Peter & Hillion, Pierre, 1999. "Implementing Statistical Criteria to Select Return Forecasting Models: What Do We Learn?," Review of Financial Studies, Society for Financial Studies, vol. 12(2), pages 405-28.
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    7. Randolph Cohen & Joshua Coval & Lubos Pastor, 2002. "Judging Fund Managers by the Company They Keep," NBER Working Papers 9359, National Bureau of Economic Research, Inc.
    8. Pesaran, M Hashem & Timmermann, Allan G, 2004. "Real Time Econometrics," CEPR Discussion Papers 4402, C.E.P.R. Discussion Papers.
    9. Luboš Pástor & Robert F. Stambaugh, . "Investing in Equity Mutual Funds," CRSP working papers 532, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
    10. Blake, David & Lehmann, Bruce N & Timmermann, Allan, 1999. "Asset Allocation Dynamics and Pension Fund Performance," The Journal of Business, University of Chicago Press, vol. 72(4), pages 429-61, October.
    11. Ferson, Wayne E & Schadt, Rudi W, 1996. " Measuring Fund Strategy and Performance in Changing Economic Conditions," Journal of Finance, American Finance Association, vol. 51(2), pages 425-61, June.
    12. Wayne Ferson & Kenneth Khang, 2002. "Conditional Performance Measurement Using Portfolio Weights: Evidence for Pension Funds," NBER Working Papers 8790, National Bureau of Economic Research, Inc.
    13. Marcin Kacperczyk & Clemens Sialm & Lu Zheng, 2008. "Unobserved Actions of Mutual Funds," Review of Financial Studies, Society for Financial Studies, vol. 21(6), pages 2379-2416, November.
    14. William N. Goetzmann & Stephen J. Brown, 2005. "Performance Persistence," Yale School of Management Working Papers ysm451, Yale School of Management.
    15. Granger, Clive & Timmermann, Allan G, 2002. "Efficient Market Hypothesis and Forecasting," CEPR Discussion Papers 3593, C.E.P.R. Discussion Papers.
    16. Edwin J. Elton, 2001. "A First Look at the Accuracy of the CRSP Mutual Fund Database and a Comparison of the CRSP and Morningstar Mutual Fund Databases," Journal of Finance, American Finance Association, vol. 56(6), pages 2415-2430, December.
    17. Berk, Jonathan B, 1995. "A Critique of Size-Related Anomalies," Review of Financial Studies, Society for Financial Studies, vol. 8(2), pages 275-86.
    18. Ferson, Wayne E & Korajczyk, Robert A, 1995. "Do Arbitrage Pricing Models Explain the Predictability of Stock Returns?," The Journal of Business, University of Chicago Press, vol. 68(3), pages 309-49, July.
    19. Halbert White, 2000. "A Reality Check for Data Snooping," Econometrica, Econometric Society, vol. 68(5), pages 1097-1126, September.
    20. Carhart, Mark M, 1997. " On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, vol. 52(1), pages 57-82, March.
    21. Grinblatt, Mark & Titman, Sheridan, 1994. "A Study of Monthly Mutual Fund Returns and Performance Evaluation Techniques," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 29(03), pages 419-444, September.
    22. William N. Goetzmann & Stephen J. Brown, 1998. "Mutual Fund Styles," Yale School of Management Working Papers ysm40, Yale School of Management.
    23. Matthew Spiegel & Harry Mamaysky & Hong Zhang, 2005. "Estimating the Dynamics of Mutual Fund Alphas and Betas," Yale School of Management Working Papers ysm353, Yale School of Management, revised 01 Apr 2005.
    24. Avramov, Doron & Wermers, Russ, 2005. "Investing in mutual funds when returns are predictable," CFR Working Papers 05-13, University of Cologne, Centre for Financial Research (CFR).
    25. Ferson, Wayne E & Harvey, Campbell R, 1993. "The Risk and Predictability of International Equity Returns," Review of Financial Studies, Society for Financial Studies, vol. 6(3), pages 527-66.
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    Cited by:
    1. Martijn Cremers & Antti Petajisto, 2006. "How Active is Your Fund Manager? A New Measure That Predicts Performance," Yale School of Management Working Papers amz2370, Yale School of Management, revised 01 May 2009.

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