NBER WORKING PAPER SERIES
TIME-VARYING FUND MANAGER SKILL
Marcin Kacperczyk
Stijn Van Nieuwerburgh
Laura Veldkamp
Working Paper 17615
http://www.nber.org/papers/w17615
NATIONAL BUREAU OF ECONOMIC RESEARCH
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November 2011
We thank the Q-group for their generous financial support. The views expressed herein are those of
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© 2011 by Marcin Kacperczyk, Stijn Van Nieuwerburgh, and Laura Veldkamp. All rights reserved.
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that full credit, including © notice, is given to the source.
Time-Varying Fund Manager Skill
Marcin Kacperczyk, Stijn Van Nieuwerburgh, and Laura Veldkamp
NBER Working Paper No. 17615
November 2011
JEL No. G00,G11,G2
ABSTRACT
Mutual fund managers can outperform the market by picking stocks or timing the market successfully.
Previous work has estimated picking and timing skill, assuming that each manager is endowed with
a fixed amount of each and found some evidence of picking skills and little evidence of timing skills
among successful managers. This paper estimates skill separately in booms and recessions and finds
that the extent to which managers focus on stock picking or market timing fluctuates with the state
of the economy. Stock picking is more prevalent in booms, while market timing dominates in recessions.
We use this finding to develop a new methodology for detecting managerial skill. The results suggest
that some but not all managers have skill. We describe the characteristics of the skilled managers and
show that skilled managers significantly outperform the market.
Marcin Kacperczyk
Stern School of Business
New York University
44 West 4th Street
KMC 9-190
New York, NY 10012
and NBER
mkacperc@stern.nyu.edu
Stijn Van Nieuwerburgh
Stern School of Business
New York University
44 W 4th Street, Suite 9-120
New York, NY 10012
and NBER
svnieuwe@stern.nyu.edu
Laura Veldkamp
Stern School of Business
New York University
44 W Fourth Street,Suite 7-77
New York, NY 10012
and NBER
lveldkam@stern.nyu.edu
An enormous literature asks whether investment managers add value for their clients and
if so, how. One way to answer this question is to decompose fund performance into stock-
picking ability a nd market-timing ability. Previous wo rk has estimated picking and timing
skills implicitly assuming that each manager is endowed with a fixed amount of each skill.
But stock picking and market timing are not talents one is born with. They are the result
of time spent working, analyzing data. Like workers in other jobs, fund managers may
choose to focus on different tasks at different points in time. This simple idea leads us
to re-estimate fund manager skill in a way that allows its nature to change, depending on
economic conditions. Our results show t ha t successful managers pick stocks well in booms
and time the market well in recessions. This suggests that skills such as stock picking and
market timing are not distinct and permanent, but instead reflect a cognitive ability that
can be applied in different ways depending on the market environment. As a financial web
site Zero Hedge writes: “It is hard for a portfolio manager to focus on the nuances of stock
selection when the prospects of a U.S. recession keep rising. . . . Simply put, the macro is
overwhelming the micro.”
1
Understanding exactly how managers add value for their clients is important because
a large and growing fraction of individual investors delegate their portfolio management
to professional investment managers.
2
Yet, a significant body of evidence finds that the
average actively managed fund does not outperform passive investment strategies, net of
fees, and af t er controlling for differences in systematic risk exposure. Instead, there is a
small subset of funds that persistently outperform. Most previous work has argued that this
1
Published on September 2 5, 2011.
2
In 1980, 48% of U.S. equity was directly held by individuals – as opposed to being held through interme-
diaries; by 2007, that fraction was down to 21.5% (French (2008), Table 1). At the end of 2008, $9.6 trillion
was invested with such intermediaries in the U.S. Of a ll inve stment in domestic equity mutual funds, about
85% was actively managed (2009 Investment Company Fac tboo k).
1
outperformance comes from stock picking and not market timing. Our results suggest that
the r eason previous studies failed to detect market- timing ability is because it is typically
displayed only in recessions, which are a small fraction of the sample periods. Once we
condition on the state of the economy, we find that mo st skilled managers exhibit both
types of skill: Those who are good stock-pickers in boo ms are also good market-timers in
recessions.
The fact that only a subset of managers add value makes it important to be able to
identify these skilled managers. Therefore, a second cont r ibution of the paper is to develop
a new measure for detecting managerial skill, that gives more weight to fund manager’s
market-timing ability in recessions and her stock-picking ability in booms. This new measure
predicts performance. We show that a subset of managers with the highest value of our skill
measure significantly outperform the passive benchmarks by 70- 90 basis points per year, in
a persistent way.
To measure skill, we construct estimates of stock picking (the covariance of por t folio
weights with the firm-specific component of stock returns) and market timing (the covariance
of portfolio weights with the aggregate component of stock returns) f or each firm in each
12-month rolling window. Then, we r egr ess these timing and picking varia bles on a recession
indicator variable to determine if skills change significantly over the business cycle. We find
that the averag e f und ma nager exhibits greater stock-picking ability in booms and a better
market-timing ability in recessions. Moreover, results from quantile regressions show that it
is the most skilled managers that vary the use of their skills most over the business cycle.
This is consistent with the idea that only some managers have skill a nd it is those mana gers
who decide how to apply that skill depending on the economic environment. Importantly,
this is not a composition effect. It is the same manager who picks stocks well in booms that
2
times the market well in recessions.
Our skill measures allow us to further investigate the nature of this stock-picking and
market-timing skill. First, do managers correctly anticipate the demands of other market
participants or do they acquire information that helps them to f orecast market fluctuations
or firm earnings? To answer these questions, we try to distinguish a manager’s ability to
forecast market o r firm-specific fundamentals from her ability to forecast market sentiment
(movements in returns that are orthogonal to fundamentals). Therefore, we estimate the
covariance of each fund’s portfo lio holdings with an aggregate fundamental shock—the in-
novations in industrial production growth. This covariance measures a manager’s ability to
time the market by increasing (decreasing) her portfolio positions in anticipation of good
(bad) macroeconomic news. We find that this fundamentals-based timing covariance rises
in recessions. Likewise, we also calculate the covariance of a fund’s portfolio ho lding s with
asset-sp ecific fundamental shocks—the unexpected innovations in earnings. This covariance
measures managers’ ability to pick stocks that subsequently experience high earnings. We
find that this fundamentals-based stock-picking covariance increases in expansions. F igure
1 summarizes our findings.
Not only do we find that managers correctly fo r ecast firm-specific fundamentals in booms
and market fundamentals in recessions, these results a re even stronger tha n those in which
timing and picking are based on stock ma r ket information. Thus, another contribution of
the paper is to show that skilled managers are learning abo ut the fundamental strengths and
weaknesses of firms and of the economy and are using that information to time the market
and pick stocks.
Next, we explore several investment strategies managers use to time the market. We find
that, on average, they hold mo r e cash in recessions, t heir portfolios have lower market betas,
3
