Review of Finance Advance Access published online on August 25, 2007
Review of Finance, doi:10.1093/rof/rfm018
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Improved Forecasting of Mutual Fund Alphas and Betas*
1 Old Lane LP
2 Yale School of Management
3 INSEAD
This paper proposes a simple back testing procedure that is shown to dramatically improve a panel data model's ability to produce out of sample forecasts. Here the procedure is used to forecast mutual fund alphas. Using monthly data with an OLS model it has been difficult to consistently predict which portfolio managers will produce above market returns for their investors. This paper provides empirical evidence that sorting on the estimated alphas populates the top and bottom deciles not with the best and worst funds, but with those having the greatest estimation error. This problem can be attenuated by back testing the statistical model fund by fund. The back test used here requires a statistical model to exhibit some past predictive success for a particular fund before it is allowed to make predictions about that fund in the current period. Another estimation problem concerns the use of a single statistical model for all available mutual funds. Since no one statistical model is likely to fit every fund, the result is a great deal of misspecification error. This paper shows that the combined use of an OLS and Kalman filter model increases the number of funds with predictable out of sample alphas by about 60%. Overall, a strategy that uses very modest ex-ante filters to eliminate funds whose parameters likely derive primarily from estimation error produces an out of sample risk-adjusted return of over 4% per annum.
JEL Classification: G12, G13
* We thank David Musto whose critique of an earlier paper lead to the creation of the eight-factor model used in this one. Additional thanks go to Jonathan Berk, Mark Carhart, Joshua Coval, Wayne Ferson, William Goetzmann, Peter Starr, Peter Bossaerts (the editor), and three referees for their comments. Finally, we thank seminar participants at INSEAD, Rutgers, the University of Michigan at Ann Arbor, the University of Calgary, and the University of Alberta and conference participants at the 2005 Winter Finance Summit, the 2005 Meetings of the Western Finance Association, and the 2005 Meetings of the European Finance Association.