Which styles of actively managed stock mutual funds outperform?

Rational Cross-Sectional Differences in Market Efficiency: Evidence from Mutual Fund Returns by PAUL H. SCHULTZ University of Notre Dame - Department of Finance & Business Economics
November 14, 2007 Abstract: There should be enough inefficiency in the market to allow returns to security analysis to adequately compensate the marginal investor for his efforts. Cross-sectional differences in the costs of analysis imply cross-sectional differences in market efficiency. Small growth stocks are especially costly to analyze and trade. Hence we would expect that the returns before expenses that smart investors earn analyzing these stock to be especially high. Over 1980 - 2006, the small growth stocks held by active mutual funds earn average abnormal returns of 0.76% per month. Large value stocks held by funds earn monthly abnormal returns of only 0.05%.
Keywords: market efficiency, mutual funds, growth stocks, small stocks JEL Classifications: G12, G14, G20
If the conclusions of the paper above are correct (I have not had time to read it yet), actively managed mutual make more sense for small cap growth stocks than for large cap value stocks. I have seen similar research for small cap vs. large cap stocks, ignoring the value/growth dimension.
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snip for brevity

This is not what the conclusions say. Are you even aware that the paper treats only mutual fund performance before expenses? From the author's draft (free on the web): "I examine returns on fund holdings rather than returns on the funds because I am interested in how well mutual funds do on their investments - not how much of their returns are passed on to their investors."
This work has no application to real investors. It is the usual grist of the academia mill, where few gems emerge.
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wrote:

Yes, but 12*0.76% = 9.12%, much higher than the typical expense ratio of a small cap mutual fund.

As usual, we disagree. In general, finance professors are not in the business of developing investment strategies for individual investors but in understanding the financial markets. I think it may be possible for some individuals to use those insights to boost their performance, but it may require refining a simple strategy presented in a paper. I can say from first-hand experience that quantitative money managers do pay attention to the research published in places like the Journal of Finance.
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The author's statement about the 0.76% abnormal return of small caps blah blah is a mere restatement of the fact that small caps have historically returned (well, from 1980-2006) much more than large caps. Does this justify a higher expense ratio for small cap funds vs. large caps, in general? I guess, if one insists on comparing apples (small cap funds) to oranges (large cap funds). Does it mean actively managed small cap funds trump passive managed small cap funds? No. And that's the choice people need to make, since all properly diversified investors with a long time horizon are going to hold both small caps and large caps.

I suspect by "simply strategy" you mean a snippet from a paper sound bited to the point where most of the paper's assumptions are ignored. Without the assumptions, the underlying point of the paper is meaningless. Its implementation becomes an exercise in gambling.

And on average, do these managers beat the indices, with expenses taken into account?
Didn't we have a bunch of these "money managers" recently re-assemble and re-package high risk mortgages into packages they claimed (magically) were lower risk?
Warren Buffett, in his typical common-sense manner, cut through the obfuscation and noted that securitizing uneconomic mortgages didn't make any sense: "I don't see any way that pooling a bunch of mortgages, changing the ownership, is going to change the viability of the mortgage instrument itself -- whether people can make the payments."
The key word is "common-sense," Beliav.
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Elle wrote:

Why do you feel this last sentence is true?

Other than expenses, which B explained, what relevant assumptions do you feel are being ignored?

Do you feel that the conclusions of this paper violate common sense? At least one other poster disagrees with you but, of course, that proves nothing.
-Will
william dot trice at ngc dot com
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snip, with all due respect Will, I think you twisted somewhat the previous exchange. Untangling within the constraints of this moderated newsgroup is a chore. I also feel an invitation to split hairs has been made, and I am not going to irritate the still poorly compensated moderators more here, or try not to. Focus your questions so that they actually state your substantive position and the relevance to financial planning, and I might respond. (Not that you should be waiting on the edge of your seat for my puny response. :-) ) Consider:

What do you think the conclusion is? What Beliavsky claimed the conclusion to be and what I think it is are different things.
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Elle wrote:

Wow, coal in the stocking again this year, eh? :) I really wasn't trying to poke you in the eye, but I think I managed to anyway. I was actually just trying to see if you would amplify your thoughts. Consider:
'The key word is "common-sense," Beliav.'
In an effort to find out what you were getting at, I wrote:

I'm sure you had a context in mind and I was trying to get you to amplify on that context without twisting the exchange.
-Will
william dot trice at ngc dot com
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This is not worth discussing if we do not agree what the conclusions are in the first place. Post what you think they are, and we can examine the paper further. Or not. :-)
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Actually, it isn't. His definition of "abnormal returns" requires that he compares individual stocks against a bunch of very similar ones - the abnormal return of a large-cap value stock is specifically as compared to a "characteristic portfolio" of very similar large cap value stocks, not the market as a whole and certainly not small caps.
I still don't buy his conclusion for other reasons related to this methodology, but it's not exactly the problem you are pointing at.
Or, rather, I don't buy that his conclusion is what Beliavsky suggested it was, nor that these results have much in the way of immediate practical application to folks building porfolios. In fact, the author himself says:
The primary contribution of this paper is the use of abnormal returns of mutual fund holdings as a measure of the efficiency of a market segment.
Note (1) "mutual fund holdings" - not actual mutual fund returns, and (2) it's about effiency of market segments, not about actual fund performance or outperformance, nor about any particular funds at all -- all the "abnormal returns" are aggregated across large collections of funds.
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Actually, it's not what you say either. I am counting three or more "definitions" of "abnormal return" in Schultz's Results and Tables section.
What is meant in the abstract is unclear. What he means in his first use of the phrase in the Intro section (and other sections) is unclear. There is a conventional definition of "abnormal return." He's not necessarily using it.
On a practical level, I would say that the paper loans some impetus for asking the question (among others): "Do indexed small cap funds beat actively managed small cap funds?" Many chatter about this, and ISTM for some of the reasons the author of Beliav's paper puts forth. I think the evidence is good that, for large caps, indexed tends to beat actively managed over the long haul. Not so much for small caps, from my reading at present anyway.
It's something I'd put the likes of joetaxpayer on, and he'd have a comprehensive answer in a week or less. ;-)
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Elle wrote:

It is true that he uses different definitions, but the main points of the paper are obviously based on the one that Bread quoted. The other types of abnormal returns are calculated to support the first and to further explore the data and eliminate possible biases. According to the author, the various calculations are all consistent.

It's clear to me. His quoted figures (0.76% and 0.5%) come directly from Table 4, which calculates abnormal return according to Bread's quote. This table certainly does not compare small caps to large caps as you implied earlier.
-Will
william dot trice at ngc dot com
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snip for brevity

Read the paragraph at the top of Table 4. It's way more complicated than BWS wrote.

That's open to interpretation of my remarks alongside the paper's findings.
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snipped-for-privacy@aol.com wrote:

This matches both my intuition and experience. All my active funds, except one, are small to mid cap. Partly, the question seems to be one of value added by the fund manager. The large cap stuff is analyzed to death. It really is a pretty efficient marketplace -- everybody knows everything.
This is much less true in the smaller cap markets. There may be zero to two analysts covering a stock, so the manager has opportunity to find something that is not known to the whole world.
-- Doug
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snipped-for-privacy@aol.com writes:
[From the paper:]

^^^^^^^^^^^^^^^

[From Beliavsky:]

If the conclusion you copied in above is correct, actively managed makes sense only for small growth if the expenses (both management *and* trading *and* tax-drag) exceed 76bp. Good luck finding that!
That said, there is more to all this than just long-term returns - there are also issues of tax efficiency and volatility, for example.
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snipped-for-privacy@fractious.net wrote:

Did you mean to say "if the expenses are less that 76bp pre month"? I think that's fairly easy to find, no?
-Will
william dot trice at ngc dot com
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My bad - I missed "per month".
I'm still not sure I buy it. I glanced over the paper (here's a link to it: http://www.cob.ohio-state.edu/fin/dice/seminars/ohio_state_20071026.pdf ) and I while his methodology of finding "abnormal returns" is somewhat better than simply comparing everything to the S&P 500 (as folks still do so often!) but, and as I said, this is only at a glance, it looks fishy to me. He talks about "abnormal returns" like this:
exceed the returns of stocks with similar characteristics
but then later on, he sometimes points to such "similar" stocks like this:
divided into one of 125 characteristic portfolios based on size, book-to-market value, and momentum
Which is to say he effectively compares each stock to one of these 125 pseudo-indices, rather than comparing a whole portfolio to the portfolio's most similar, say, morningstar-style box. In theory good. In practice, he ends up with some of those pseudo-indices having as few as 10 stocks. Not much of a benchmark, if you ask me, especially since nobody actually invests in any funds based on those 125 pseudo-indices. (he calls them "characteristic portfolios").
I'd be curious what happens if he were to make it much broader slices of the market - more along the lines by which both fund evaluations and portfolio managers actually work - again, more like the morningstar boxes or, say, the DFA funds.
Lastly, the author himself points out the following:
Empirical evidence generally supports the hypotheses that mutual funds underperform after expenses. In the classic early study of mutual funds performance, Jensen (1969) examines the returns after expenses of 115 mutual funds over the 1955-1964 period. Despite a survivorship bias in his data, he estimates that on average, mutual funds underperformed by about 1.1% per year. This conclusion held even after adding back all expenses except brokerage commissions. In a comprehensive study of the returns to 1,892 diversified equity funds over 1962-2003, Carhart (1997) finds that on average, the funds slightly underperformed the market. After adjustment for characteristics of fund holdings though, underperformance was more striking. Funds tended to overweight small firms, and firms with low book-to-market ratios in their portfolios. After adjusting for these factors, funds on average underperformed by just under 2% per year.
Upshot of all of this -- for the most part, indices still makes sense for most people.
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snipped-for-privacy@fractious.net wrote:

I think you're right if the intent is to invest in equities via mutual funds. However, I think the author was trying to study the rewards allotted to the individual investor that invests in individual securities as opposed to mutual funds, and then using actively managed funds as a proxy for the portfolios of smart (in the investing sense) investors.
Your point about the author's construction of indices for comparison is well taken, I particularly found it odd that he used momentum as one axis of his "style boxes". Not necessarily incorrect, but odd.
-Will
william dot trice at ngc dot com
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