The Need for Actively Managed Mutual Funds

Abstract

Superior actively managed mutual funds have numerous attributes that assist in their selection. These attributes are identified above. These portfolio managers may be normally be characterized as having an eclectic, concentrated, and wide ranging value driven investment style, which results in a large degree of unique portfolio risk.The unique investment style carries larger risk with respect to six of the nine elements of diversification risk. To the extent these larger risks are properly descriptive of these funds, their portfolio managers must overcome a variety of diversification risks that accompany their style of managing money. But, there are a few portfolio managers with reputations for doing so, and for adding a few points of long-term performance.However, independent thinking portfolio managers could greatly reduce their analytical burden. They could join the crowd that charge fees for active management, but actually herds portfolio holdings around benchmark indexes or high performance funds. Thankfully, these entrepreneurial portfolio managers are not programmed that way. And, they contribute to market efficiency. Vive la difference!Finally, a recent study by Kacperczyk, Sialm and Zheng (2005) finds that mutual fund portfolio managers with concentrated portfolios have skills related to specific industries. On average, concentrated portfolios outperform diversified portfolios after controlling for differences in risk and investment style.They find that better stock selection and style timing abilities are also more evident among portfolio managers who hold concentrated portfolios. Further, the trades of concentrated portfolios add more value than do those of diversified portfolios.Their findings thus support the value of active mutual fund portfolio management. Portfolio managers with concentrated portfolios follow distinct investment styles, which over-weight growth and small-cap stocks. On the other hand, diversified portfolios more closely resemble market portfolios. Investment ability is thus more evident among portfolios concentrated in a few industries, where portfolio managers exploit informational advantages.Their findings also differ from the above approaches in the following ways. First, small-cap or growth stocks outperform value stocks, especially large value stocks, across all performance measures. Second, portfolio managers focus by design on a few industries to exploit informational advantages. These issues aside, both approaches are consistent in the use of concentrated portfolios.