Challenging the Conventional Wisdom on Active Management: A Review of the Past 20 Years of Academic Literature on Actively Managed Mutual Funds

Abstract

Just over 20 years have passed since the publication of Mark Carhart’s landmark 1997 study on mutual funds. Its conclusion—that the data did “not support the existence of skilled or informed mutual fund portfolio managers”—was the capstone of an academic literature, which began with Michael Jensen in 1968, that formed the conventional wisdom that active management does not create value for investors. We review the literature on active mutual fund management since the publication of Carhart’s work to assess the extent to which current research still supports the conventional wisdom. Our review of the most recent literature suggests that the conventional wisdom is too negative on the value of active management.

Disclosure: This research was supported by the Investment Adviser Association’s Active Managers Council. Martijn Cremers currently serves as an independent director at Ariel Investments and a consultant to Touchstone Investments and State Street Associates.

Editor’s note

Submitted 27 January 2019

Accepted 23 May 2019 by Stephen J. Brown

Acknowledgment

We thank Karen Barr, Brigitte Dooley, Theresa Hamacher, Yuekun Liu, and Qing Yan for their comments, suggestions, and citation assistance. We also thank Executive Editor Stephen Brown, co-editor Steven Thorley, and reviewers Nicole Boyson and Yong Chen. Any errors are our own.

This article was externally reviewed using our double-blind peer-review process. When the article was accepted for publication, the authors thanked the reviewers in their acknowledgments. Nicole Boyson and Yong Chen were the reviewers for this article.

Notes

¹ Carhart (1997) has, according to Google Scholar, 14,758 citations as of 18 June 2019.

² All data in this section are from the 2017 and 2018 Investment Company Institute handbooks except where noted.

³ For early evidence of persistence, see Grinblatt and Titman (1992); Elton, Gruber, Das, and Hlavka (1993); Hendricks, Patel, and Zeckhauser (1993); Goetzmann and Ibbotson (1994); Brown and Goetzmann (1995); Elton, Gruber, and Blake (1996a); and Wermers (1997).

⁴ In the section “The Appropriate Model for Evaluating Fund Performance,” we discuss in detail the merits of each of the common benchmarking approaches.

⁵ Riley (forthcoming) closely replicated the procedure that Kosowski et al. (2006) used to draw that particular conclusion and found “no evidence of stock selection ability in excess of costs” (p. 1) in recent years.

⁶ Baker and Wurgler (2006) stated that “one possible definition of investor sentiment is the propensity to speculate” (p. 1648).

⁷ Andrikogiannopoulou and Papakonstantinou (forthcoming) found that the “false discoveries” technique “underestimates the proportion of nonzero-alpha funds” because of “the low signal-to-noise ratio in fund returns” (p. 1).

⁸ The disposition effect refers to investors treating unrealized losses and unrealized gains differently. Investors tend to avoid selling assets with unrealized losses because they want to “get even” before selling.

⁹ De Silva, Sapra, and Thorley (2001) cautioned that performance evaluation requires adjustments for changes in “return dispersion over time” as “an excess return of ±10 [percentage points] in a narrow-dispersion year like 1996 is a much more material indicator of performance than the same excess return in a wide-dispersion year like 1999” (p. 39).

¹⁰ Jiang and Verardo (2018), measuring “the tendency of fund managers to follow the trades of the institutional crowd,” found that the funds that do not follow the crowd outperform those that do “by over 2% per year” (p. 2229). Wei, Wermers, and Yao (2015) showed that the contrarian funds “generate superior performance both when they trade against and with the [non-contrarian funds]” (p. 2394).

¹¹ Among other papers, the following studies provided additional empirical results that appear inconsistent with investors acting rationally with respect to capital allocations: Goetzmann and Peles (1997); Wilcox (2003); Elton, Gruber, and Busse (2004); Barber, Odean, and Zheng (2005); Cooper, Gulen, and Rau (2005); Frazzini and Lamont (2008); Sensoy (2009); Bailey, Kumar, and Ng (2011); Solomon, Soltes, and Sosyura (2014); Barber, Huang, and Odean (2016); and Phillips, Pukthuanthong, and Rau (2016).

¹² Several studies have considered the value of investing in individual securities based on socially responsible criteria. Examples are Hong and Kacperczyk (2009); Deng, Kang, and Low (2013); Eccles, Ioannou, and Serafeim (2014); Kim, Li, and Li (2014); Flammer (2015); and Nagy, Kassam, and Lee (2016).

¹³ O’Neal and Page (2000); Lin and Yung (2004); Chiang, Kozhevnikov, Lee, and Wisen (2008); Derwall, Huij, Brounen, and Marquering (2009); and Hartzell, Mühlhofer, and Titman (2010) found no evidence of outperformance. Gallo, Lockwood, and Rutherford (2000); Kallberg, Liu, and Trzcinka (2000); Fuerst and Marcato (2009); and Kaushik and Pennathur (2012) found some evidence of outperformance.

¹⁴ Funds that invest in domestic assets can calculate their daily NAVs by using that day’s closing market prices. Because of time zone differences, the prices used for international assets, however, may be stale or still fluctuating. Bhargava, Bose, and Dubofsky (1998); Bhargava and Dubofsky (2001); Goetzmann, Ivković, and Rouwenhorst (2001); Zitzewitz (2006); and Chua, Lai, and Wu (2008) showed how this issue can make the NAV inaccurate for international funds and demonstrated that short-term traders can exploit that inaccuracy. Since that research was conducted, however, changes in regulation and fund practices may have altered the viability of “time zone arbitrage” strategies.

¹⁵ See, for example, diBartolomeo and Witkowski (1997); Kim, Shukla, and Tomas (2000); Elton et al. (2003); Hirt, Tolani, and Philips (2015); Bams, Otten, and Ramezanifar (2017); and Mateus, Mateus, and Todorovic (2017).

¹⁶ Edelen (1999); Johnson (2004); Greene, Hodges, and Rakowski (2007); Dubofsky (2010); Rakowski (2010); and Fulkerson and Riley (2017) focused on the cost of providing liquidity at the individual fund level. The studies of Chen, Goldstein, and Jiang (2010); Coval and Stafford (2007); Dyakov and Verbeek (2013); Shive and Yun (2013); Goldstein et al. (2017); and Parida and Teo (2018) have implications at the fund level but also discussed general market impacts.

¹⁷ See Wermers (2000); Yan (2006); Nascimento and Powell (2010); Simutin (2014); and Chernenko and Sunderam (2016) for a discussion of the trade-offs associated with mutual fund cash holdings.

¹⁸ See, for example, Getmansky, Lo, and Makarov (2004); Bollen and Pool (2009); Agarwal, Fos, and Jiang (2013); Aiken, Clifford, and Ellis (2013); Hodder, Jackwerth, and Kolokolova (2014); Jorion and Schwarz (2014a, 2014b); Patton, Ramadorai, and Streatfield (2015); and Dimmock and Gerken (2016).