A recent article in Morningstar discusses a powerful—yet widely unknown and unused– equity fund performance predictor that was introduced in a 2005 research paper and subsequently shared in the Journal of Finance.
The paper, titled “Judging Fund Managers by the Company They Keep,” argued that instead of ranking funds by past performance, they should be evaluated based on the composition and quality of their portfolios—which can be determined from the fund’s most recent SEC filing.
“The authors tested each stock in a fund’s portfolio to see what other funds held that security. If the stock was possessed mostly by funds that had excellent track records, then it was scored highly. If on the other hand, the security was favored by second- and third-rate funds, it received a poor score.”
The research team then calculated an average of each fund’s individual stock scores, weighting the securities by their importance to the portfolio (for examples, “counting a 5% position 5 times more heavily than a 1% position”). “The single final number represented the quality of the actively run funds that had similar holdings,” the article notes, adding, “The higher the number, the classier the fund’s cousins, and therefore the better its future performance.”
According to the article, “the strongest version of the formula found that the top-decile funds subsequently beat the bottom-decile funds by an annualized 736 basis points. That is…big.” But while the paper convinced academics, it wasn’t as widely embraced by practitioners: “Despite the strength of the paper’s results, no investors to my knowledge use its measure when selecting funds—not retail financial advisors, nor institutional consultants.”
The article concludes by noting that Morningstar has duplicated the study and expanded its reach by including international stock funds—and will release its findings in upcoming articles.
Note: the article explained that the study’s calculations were based on the Carhart Four Factor Model, which adjusts for investment style.