Abstract

Using a sample free of survivor bias, I demonstrate that common factors in stock returns and investment expenses almost completely explain persistence in equity mutual funds’ mean and risk-adjusted returns. Hendricks, Patel and Zeckhauser’s (1993) “hot hands” result is mostly driven by the one-year momentum effect of Jegadeesh and Titman (1993), but individual funds do not earn higher returns from following the momentum strategy in stocks. The only significant persistence not explained is concentrated in strong underperformance by the worst-return mutual funds. The results do not support the existence of skilled or informed mutual fund portfolio managers.

Scientific Portfolio AI- Generated Summary

In this paper, Mark M. Carhart examines the persistence of equity mutual funds’ mean and risk-adjusted returns. He explores the factors that contribute to this persistence, including common factors in stock returns and investment expenses.

Carhart’s analysis indicates that Jegadeesh and Titman’s one-year momentum in stock returns accounts for Hendricks, Patel, and Zeckhauser’s hot hands effect in mutual fund performance. However, funds that earn higher returns in the short term do not necessarily continue to outperform in the long term.

Carhart also finds that neither expense ratios nor turnover completely explain the persistent spread and pattern in 4-factor abnormal returns on mutual funds. About 0.6 percent of the 5 percent annual spread in net alphas can be explained by expense ratios, and variation in transaction costs accounts for another 1.4 percent. The most striking result is the size of the spread captured by the strong underperformance in the lowest-ranked funds, even after adjustments for expenses and transaction costs.

Overall, Carhart’s findings have important implications for investors looking to invest in mutual funds. Buying last year’s top-decile mutual funds and selling last year’s bottom-decile funds yields a return of 8 percent per year. Of this spread, differences in the market value and momentum of stocks held explain 4.6 percent, differences in expenses and transaction costs explain 2 percent, and the remaining 1.4 percent is unexplained.

In conclusion, Carhart’s analysis suggests that persistence in mutual fund performance is driven by a combination of common factors in stock returns and investment expenses. While short-term performance can be a useful indicator of future performance, investors should be cautious about relying solely on past performance when selecting mutual funds. Instead, they should consider a range of factors, including expenses, transaction costs, and the market value and momentum of stocks held, when making investment decisions.