Actively managed equity mutual funds with a low degree of portfolio overlap hold higher-returning stocks. This is true even when grouping funds based on investment style and stock category.
Investment distinction is a predictor of performance. The advantage is notable around earnings announcement periods and during volatile markets.
The negative relationship of performance with funds whose holdings are more similar cannot be explained by fund characteristics, such as size, flows or tracking error.
The return advantage of funds with less similar portfolios relative to their peers weakened after 2004. The breakpoint was caused by the U.S. Securities and Exchange Commission (SEC) changing the frequency of portfolio holdings disclosure from semiannually to quarterly. Following this change, the returns of funds with more distinct historical performance worsened. These funds also had lower degrees of holdings similarity, indicating a more unique investment strategy.
The author theorizes that more frequent disclosure reduced the ability of any particular fund manager to take advantage of any information their peers do not have. Prior research backs up the theory that concentration is optimal for well-informed investors and that managers following distinguished peers do better.
If more frequent disclosure of returns did play a role, then it would explain why more unique funds still have a performance advantage around earnings season and during volatile market conditions.
Fund managers are incentivized to be active, with their performance—and thus their compensation—measured relative to a benchmark. As a precaution, fund contracts include error tracking constraints, which require managers to stay within a margin of performance with regard to the chosen benchmark.
A limit on managers’ active strategies, tracking error constraints are implemented in times of market volatility. The degree of portfolio overlap increases in parallel to funds moving toward benchmark performance during volatile periods, and the negative relationship between holdings similarity and performance is also amplified. The negative price pressure managers create on common assets spills over to connected funds.
Source: “Common Holdings and Mutual Fund Performance,” by Shema F. Mitali; SSRN, August 2019.
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