When Is Stock Picking Likely to Be Successful? Evidence from Mutual Funds

Abstract

Consistent with a costly arbitrage equilibrium in which arbitrage costs insulate mispricing, this study finds that mutual fund managers have stock-picking ability for stocks with high idiosyncratic volatility but not for stocks with low idiosyncratic volatility. These findings suggest that fund managers and other investors may want to pay special attention to high-idiosyncratic-volatility stocks because they provide fertile ground for stock picking. The study also finds that the stock-picking ability of the average mutual fund manager declined after the extreme growth in the number of both mutual funds and hedge funds in the late 1990s.Whether mutual fund managers have stock-picking ability is an important question for both practitioners and mutual fund investors. The empirical evidence is mixed. In this article, we try to answer this question from a fresh angle: If mutual fund managers do possess stock-picking ability, when are they most likely to be successful?We found that mutual fund managers have stock-picking ability in stocks with high idiosyncratic volatility but not in stocks with low idiosyncratic volatility. This finding is consistent with a costly arbitrage equilibrium in which unhedgeable volatility prevents risk-averse arbitrageurs from taking large positions in mispriced securities, and thus, mispricing persists. An alternative explanation for this finding is that high-idiosyncratic-volatility stocks have large streams of company-specific information, thereby providing opportunities for company-specific information production and stock picking. One practical implication of this finding is that fund managers and other investors may want to pay special attention to high-idiosyncratic-volatility stocks because they provide fertile ground for stock picking.We also found little evidence of stock-picking ability among mutual fund managers in the later part of our sample (after the mid-1990s), although fund managers do seem to make better trades in high-idiosyncratic-volatility stocks. One explanation for this finding could be the large increase in the number of both mutual funds and hedge funds that occurred in the late 1990s. Increased competition among managers may have caused a decrease in the number of profitable trading opportunities, and the large increase in the number of managers may have caused the quality of the average mutual fund manager to decline.