Over $5.5 trillion are currently managed by the U.S. mutual fund industry, with roughly $3 trillion managed in equity funds. A significant portion of this amount is actively managed by money managers who presumably rely on superior stock-selection skills to outperform passive strategies. Several billion dollars per year are expended by these active fund managers in pursuit of under priced stocks, well in excess of the amount that is typically expended by their passive, index-fund counterparts.
Although investors seem to trust the ability of these mutual fund managers to invest their savings, academics have repeatedly questioned the ability of funds to systematically pick under priced stocks. Starting with Jensen (1968), many studies claim that the net return provided by the average actively managed mutual fund is inferior to that of a comparable passive benchmark.
While the evidence supportive of mutual fund managers possessing stock-selection talents is weak, it is possible that these tests, which are based on aggregate mutual fund holdings, are not sufficiently powerful to detect such talents. For example, mutual fund holdings, in aggregate, account for between three and 13 percent of the market value of all publicly traded stocks in the U.S. between 1975 and 1994; hence, it is unlikely that the funds, as a group, hold stocks that outperform their benchmarks by a large amount.
To enable more powerful tests of the stock-selection abilities of fund managers, we examine the performance of stocks held by mutual funds as well as stocks actively traded by the funds. Examining the performance of stocks held and traded by mutual funds focuses on the issue of whether the consensus opinion of the entire mutual fund industry about a stock represents superior information about the value of that stock. Further, we expect active stock trades to represent a stronger manager opinion than the passive decision of holding an existing position in a stock, since the latter may be driven by non-performance related reasons such as concerns over transaction costs and capital gains taxes. We would, therefore, expect any evidence of stock selection ability to be more discernible by examining trades rather than holdings.
