Active Sector Funds and Fund Manager Skill

Abstract

The authors investigate the performance of active sector funds whose potential outperformance has not been exhausted entirely by decreasing returns to scale. The authors document that despite good track records, most sector funds are relatively smaller than their equilibrium fund sizes, at which they are expected to generate zero net alphas. In particular, from 1998 to 2016, a passive indexation strategy of actively managed sector funds earns an annual benchmark-adjusted return of 5.70% and a monthly alpha of 27 bps. Moreover, the strategy’s outperformance is present in market downturns (i.e., resilient to tail risk) and robust to change of rebalancing frequency and inclusion of expenses. Efficient diversification and underappreciated skill, illustrated by an alpha-arithmetic to guide similar strategies, explain the strategy’s success.

TOPICS: Manager selection, mutual fund performance, exchange-traded funds and applications

Key Findings

• • Using data on active equity sector mutual funds, the authors find that an equal-weighted portfolio of sector funds delivers reliable alpha that is resilient to market downturns and only requires infrequent rebalancing.

• • Active sector funds individually show only weak evidence of selection skill, which may make them somewhat undersized, but an equal-weighted portfolio of them brings out the skill signal and diversifies away much of the alpha-seeking noise.

• • A portfolio of sector funds benefits from two layers of diversification: It not only washes off the sector-specific risk, it also diversifies the manager-specific active risk because managers in different sectors often make independent active bets.