As published on Advisor Perspectives January 30, 2023

Conventional wisdom has it that active investment managers, while capable of outperforming at times, are unable to generate persistent alpha. Among the studies supporting this belief was one conducted by the Wall Street Journal. Its 2017 article, The Morningstar Mirage, was based on Morningstar’s “star” ratings of active mutual funds.

Examining star ratings for nearly 11,000 funds over a 14-year period, the authors concluded: When funds picked up a fifth star for the first time during the period included in the Journal’s analysis, half of them held on to it for just three months before their performance and rating weakened… The findings were especially stark among U.S.-based domestic equity funds. Of those that merited the five-star badge, a mere 10% earned five stars for their performance over the following three years. Only 7% merited five stars for the following five years, and 6% did for 10 years.

This paper introduces market barometers that are based on measurable and persistent investor behavior. I test the ability of U.S. market, international market, and capitalization barometers to predict S&P 500, MSCI EAFE, and Russell 2000 returns, respectively. The empirical results for January 1981–December 2020 are statistically and economically significant and cannot be explained by trailing equity returns or the Institute of Supply Management Purchasing Managers’ Index,¹ one of the best measures of economic activity. Barometers are used to develop a set of trading rules that show evidence of superior performance when compared with relevant benchmarks over the period evaluated.

In our 2019 book, Return of the Active Manager, we declared that active equity management was alive and well in spite of the recent movement to index investing. We provided numerous ideas on how to improve the evaluation of investment opportunities as well as manage equity portfolios, from the perspective of behavioral finance. 

Little did we know that a new golden era of active equity would commence shortly thereafter.

We propose a novel predictor of equity mutual fund performance, “strategy consistency”, defined as the degree to which a fund picks stocks most chosen collectively by managers with a similar self-declared principal investment strategy. Using a proprietary strategy classification based on textual analysis of fund prospectuses, we show that high-consistency funds earn significantly higher abnormal returns than low-consistency funds. Moreover, high-consistency funds with the strongest prior-month performance earn significantly positive abnormal returns of 4% per annum. Our results help explain why most mutual funds underperform their benchmarks; they pick stocks that do not closely align with their primary strategy.

Published on Proactive Advisor Magazine June 23, 2021

Emotional investing errors are a significant impediment to building wealth over the long term. What are two of the most debilitating errors, and how can financial advisors help their clients avoid them?

Published on Proactive Advisor Magazine March 10, 2021

Bear markets trigger powerful emotions for many investors. Awareness of investor biases—which are compounded in bear markets—can help both advisors and their clients avoid making behavioral mistakes in turbulent times.