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‘Copycatting’ doesn’t work in the mutual fund world



Superior fund managers can’t be identified in advance, says research co-authored by Cambridge Judge Business School finance professor

Suppose you want to find the smartest student in a classroom, you would look for the one from whom others copy their homework.

New research by a team including Raghavendra Rau, Sir Evelyn de Rothschild Professor of Finance at Cambridge Judge Business School, draws on this to argue that in the fund management world, even fund managers who seek to copycat – those with the most incentive to find their smartest peers – don’t have the capability to identify superior fund managers in advance.

Amidst much debate in fund-management literature on whether or not fund managers possess skill – some papers say they do, others say they don’t – the new research finds no evidence that even other mutual fund managers are able to find the smartest fund managers in advance, which leaves little hope for the average investor seeking fund managers who can deliver the best future returns.

The research paper, entitled “Detecting superior mutual fund managers: evidence from copycats”, is to be published in an upcoming edition of the Review of Asset Pricing Studies Journal.

“We found that copycat fund managers simply copy funds that have great past performance – exactly as average investors do.” said Rau.

The research looks at US actively managed mutual funds between 1991 and 2013, and labels a fund a “copycat fund” if the changes in portfolio weights for the copycat matches by 75 per cent to 90 per cent the target fund’s trades in two or more consecutive periods. The chance of such an occurrence via random, independent draws from the set of available investment assets is infinitesimal.

“To our knowledge, we are the first to use portfolio holdings to identify actual copycat funds, documenting which funds they choose to copy, and the performance implications for both the copycat and target fund,” the paper says.

Copycats select funds with strong prior performance and high investor inflows for which performance reverses shortly after copying initiation

How effective is copying longer term? Over a horizon of up to four years after copying begins, the performance of the copycat funds decline by an average of 3.2 per cent. The research concludes: “Copycats select funds with strong prior performance and high investor inflows for which performance reverses shortly after copying initiation.”

The research found, furthermore, that if superior fund managers exist, “the source of skill lies in private information obtained by these managers” – reinforcing information models indicating that private, but not publicly available information, can be profitable.

“Our results do not imply that superior mutual fund managers do not exist, just that ex ante identification, if possible, is extremely difficult and few investors possess this ability,” the paper says.

The research paper is authored by Blake Phillips of the School of Accounting and Finance at the University of Waterloo in Canada, Kuntara Pukthuanthong of Trulaske College of Business at the University of Missouri, and Professor Rau of Cambridge Judge Business School, University of Cambridge.