Which path, stock picking (company analysis) or industry picking (economic trend analysis) is the more direct to investing outperformance? In their December 2007 paper entitled “Mutual Fund Industry Selection and Persistence”, Jeffrey Busse and Qing Tong examine the relative importance of industry selection and stock selection in the performance of actively managed mutual funds. Using quarterly stockholdings during 1980-2006 for a large sample of actively managed U.S. equity mutual funds, along with associated stock return data, they find that:
- Industry selection generates on average about half of mutual fund alpha. This contribution is remarkably stable across the sample period. (See the table below.)
- The correlation between the industry and stock components of mutual fund alpha is 0.06, indicating that the underlying selection skills are largely unrelated. In fact, 47% of sample funds underperform one aspect of selection while outperforming the other.
- Quarter-to-quarter persistence across the full range of performance comes from industry selection. Although the stock-selection component of alpha persists among top performing funds, it reverses among poor performers. Results suggest that investors should focus on industry selection ability when using past performance to select funds.
- Unlike stock selection, industry selection is not subject to diminishing returns. While outperforming funds are unable to maintain strong stock selection alpha as assets increase, they do maintain strong industry selection alpha. Industries appear to provide ample opportunities for incremental investment. This lack of relationship between fund size and industry selection alpha helps explain why this alpha persists.
The following table, taken from the paper, shows the mean fraction of total alpha attributable to industry selection over quarterly periods for a sample of 3,959 funds over various subperiods during 1980-2006. The single-factor alpha adjusts for overall market performance. The three-factor alpha adds adjustments for firm size and value (book-to-market). The four-factor alpha further adds an adjustment for momentum. The table shows that the contribution of industry selection is very stable over time.
Across the entire sample, the risk-adjusted fractions are 0.58, 0.52 and 0.52, respectively. Funds invested in passive industry indexes weighted as in their actual portfolios would generate roughly half of their actual abnormal performance.
In summary, actively managed mutual funds on average generate about half their value by picking the right industries rather than the right stocks. This big-picture skill, not company analysis, accounts for fund performance persistence.
Investors may want to ensure that managers of their actively managed funds emphasize being in the right industries as much as being in the right stocks.
