High turnover helps ‘hot’ managers sustain runs

Growth-equity portfolio managers who shoot the lights out should keep right on shooting, according to a new study on investment performance.

High portfolio turnover and heavy cash flow – often buoyed by a “reputation effect” – distinguished the mutual fund managers with the “hottest hands,” in a new study by University of Maryland business professor Russ Wermers. It looked at equity mutual fund returns from 1975 to 1994, particularly the top performing 20% and the bottom performing 20% each year.

He found that the top growth fund managers in any year consistently outperformed that year’s bottom growth fund managers for an average of the next three years, thus displaying “hot” hands.

The outperformance declined steadily in the three years after a manager hit the top 20%, although the top managers still beat the bottom 20% after year four. Mr. Wermers found that winners beat losers by an average of 4 percentage points the first year, 3 percentage points the second year and 2 percentage points in both the third and fourth years.

“The strongest evidence of performance persistence exists in growth-oriented funds with high levels of turnover,” says Mr. Wermers.

As the outperformance of the top funds waned over the four-year period, so did trading activity, he found.

Cash flow played a role in helping hot managers maintain their edge. The top 5% of performers gathered an average of 31% in cash flow per year, while the bottom 5% had outflows of about 6% per year. With the steady flow of cash, the winners continued to “ride the wave” by piling more money into the top-performing stocks. The losers, on the other hand, weren’t able to invest substantially on momentum because of cash restraints. They would have needed to liquidate some securities to replace them with hot stocks.

The winning funds were also buoyed by the reputation effect, which can last about three years. Based on strong performance one year, investors continue to disproportionately invest new cash into hot funds during the second and third years after the ranking period, when the return spread is much lower.