Active opportunity and fund performance

Abstract

The active funds industry is large and growing. However empirical evidence suggests that the average active fund produces negative risk-adjusted performance after expenses. This is commonly taken as evidence that active fund managers lack the skills to justify the fees they charge. Existing studies look at performance over a sample period as a whole, without conditioning on the active opportunity set faced by fund managers. Yet active opportunity is not constant and has a major influence on the success of active strategies. This dissertation investigates the impact of active opportunity, as measured by cross-sectional dispersion in stock returns, on active fund performance. I find that a positive relation exists between active opportunity and the average performance of active funds. During periods of high return dispersion, in which active strategies have the greatest impact on returns, active fund performance on average significantly exceeds that achieved during lower dispersion months, in which active strategies are of lesser effect. Stratifying my sample based on the activeness of funds' strategies reveals that the positive relation between dispersion and fund performance is increasing in the activeness of the fund. A portfolio comprising the least active funds significantly underperforms when dispersion is low and does not improve when dispersion is high. A portfolio of the most active funds, on the other hand, does not significantly underperform in low dispersion months and achieves significantly higher performance in high dispersion months. Moreover, the outperformance of the most active funds relative to the least active funds documented in the literature is largely concentrated in months of high return dispersion. Bootstrap simulations performed to distinguish skill from luck in fund performance confirm that the prevalence of managerial skill significantly increases with fund activeness. Regardless of the performance metric employed, the least active fund portfolio contains the lowest prevalence of manager skill, with the highest prevalence of skilled managers contained within the most active portfolio of funds. Show more