At the most recent meeting, the Federal Open Market Committee has decided to keep the key interest rate unchanged. The financial press lit up with speculation: What does it mean for the stock market? Will this decision have a different impact on different stock categories? After each major market event, investors start searching for a narrative that will help predict future winners and losers – but only a few can accurately anticipate these shifts and come out on top.
As behavioral economists would argue, markets are often driven by narratives. At times, these narratives favor small stocks, while at other times, consistently profitable blue-chip stocks are predicted to do well. Yet during other periods, growth stocks, or even contrarian investment strategies emerge as the winners.
This time, the Fed’s pessimism about inflation dampened expectations for substantial interest rate cuts in the near future. As James Mackintosh explained in his widely-read column, big companies are poised to do well because they have access to cheaper capital. Moreover, many have stashed up cash on their balance sheets, which will continue to earn high interest rates. In contrast, small companies may rely more heavily on shorter-term debt and would have to refinance at higher rates, reducing their future profits.
So large stocks win and small stocks lose. Are money managers able to anticipate these changing narratives? Are they able to correctly predict the winning and losing stock categories?
In a recent paper, we investigate whether managers of active equity mutual funds change their bets across stock categories over time. Unlike passive managers who follow a pre-specificized stock index, active money managers pick stocks with high expected returns – they try to predict the future in their investment decisions.
The analysis uncovers the following: (1) active mutual funds change their bets across stocks with different characteristics over time, (2) these portfolio changes predominantly occur in response to the fund's past performance, and (3) many managers lose money changing their portfolio tilts, though some exhibit skill at doing this.
Why are these results surprising?
The first result is somewhat unexpected because actively managed mutual funds do not have a lot of leeway to switch their bets across stocks with different characteristics. Funds must report their investment objective in the prospectus, and this stated objective largely determines the types of stocks that the fund should hold. For instance, funds that seek growth would invest in growth stocks; conversely, income funds typically hold consistently profitable dividend-paying stocks. The characteristics of stocks held by a fund are succinctly described by the Morningstar style box, which illustrates a fund’s portfolio positioning in a three-by-three grid, in which three stock size groups (small, medium, large) intersect with three expected growth groups (value, blend, and growth). The fact that funds jump around between stock categories appears inconsistent with their stated investment objective.
The second result is surprising because if funds were shifting their bets in response to changing market conditions, their investment style changes would coincide with those made by other funds and would be largely unrelated to their own past performance. However, the changing styles are not explained by time, and are particularly large following quarters of past underperformance. Therefore, the likely explanation is that funds change styles not so much in response to the changing market conditions, but rather to signal to investors that they will be employing a different investment strategy and consequently, their performance will improve.
The last result may not come as a surprise to academics, as the academic literature has demonstrated that it is difficult, if not impossible, to time market trends. Even when investor narratives shift following significant market events, stock prices may incorporate this information with a minimal delay.
That said, some managers are better than others at timing their investment style changes. Managers who have consistently made money from a fund’s style changes in the past – referred to as managers with a high “tactical investment skill” – continue to outperform the managers with the low “tactical investment skill,” earning a return differential of 1.6% per year. This magnitude is larger than a typical management fee that actively managed funds charge investors for all the hard work they do trying to predict the future.
Unfortunately, an average actively managed fund does not justify the management fee. Therefore, when choosing among actively managed funds, it is important to try to identify those for which the flexibility of choosing portfolio tilts actually pays off and does not simply erode returns through trading costs.
The next time a new narrative emerges about where different market sectors are headed, only skilled managers who can anticipate this change and tilt the portfolio accordingly before everyone else does stand to gain.
