The payback of mutual fund selectivity in European markets

• DOI: http://doi.org/10.1111/eufm.12160
• Date: 01 January 2019
• Published date: 01 January 2019

DOI: 10.1111/eufm.12160

ORIGINAL ARTICLE

The payback of mutual fund selectivity in

European markets

Feng Dong

1

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John A. Doukas

2

1

Department of Finance, Strome College

of Business, Old Dominion University,

Constant Hall, Suite 2169, Norfolk,

VA 23529-0222, USA

Email: fodng@odu.edu

2

Department of Finance, Strome College

of Business, Old Dominion University,

Constant Hall, Suite 2080, Norfolk,

VA 23529-0222, USA

Email: jdoukas@odu.edu

Abstract

Is European fund management selectivity skill (1 −R

2

)

profitable (alpha)? To examine this question, we use a

sample of 2,947 actively managed domestic equity mutual

funds from 11 European countries. We find that high fund

selectivity generates significant investor gains. The results

are robust to investor sentiment and stock-market dispersion

conditions. Moreover, we investigate the moderating effect

of country characteristics on the profitability of fund

selectivity and find that managers' selectivity ability is more

valuable in countries with high economic development,

strong legal system, small but highly liquid equity markets,

and young mutual fund industries.

KEYWORDS

European fund selectivity skill, fund manager skill, fund performance

JEL CLASSIFICATION

G11, G14, G20, G23

1

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INTRODUCTION

Since their invention in 1924, mutual funds have become an increasingly important investment

instrument, attracting a large amount of capital from individual investors. By the end of 2014, the total

value of assets managed by mutual funds exceeded US$31 trillion, which represented a 20% growth

rate since 2007 (Investment Company Institute, 2015). While numerous studies have acknowledged

the extremely important role of the mutual fund industry in the context of the US financial markets,

they have also investigated the relation between mutual fund performance and fund managers' skills

(Amihud & Goyenko, 2013; Berk & van Binsbergen, 2015; Brands, Brown, & Gallagher, 2005;

The authors are grateful to an anonymous referee and associate editor for their helpful comments and suggestions.

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© 2017 John Wiley & Sons, Ltd. wileyonlinelibrary.com/journal/eufm Eur Financ Manag. 2019;25:160–180.

Carhart, 1997; Cremers, Ferreira, Matos, & Starks, 2016; Cremers & Petajisto, 2009; Daniel, Grinblatt,

Titman, & Wermers, 1997; Kacperczyk, Sialm, & Zheng, 2015; Malkiel, 1995). Despite the depth of

this literature, there is still no consensus with respect to the sources behind the performance of mutual

funds. While the most recent studies (Amihud & Goyenko, 2013; Berk & van Binsbergen, 2015) stress

the importance of fund management selectivity (skill), they only do so in the context of the US mutual

fund industry.

As of the end of 2014, the European mutual fund industry had more than US$9.5 trillion in assets

under management, which was 31% of the world's total mutual fund industry. To date, while the mutual

fund industry in Europe is the second largest mutual fund industry in the world and plays an important

role in the world economy, it is unknown whether fund performance is attributed to fund management

selectivity skill. To the best of our knowledge, no empirical study has analyzed the performance

and skill of European fund managers. Whether European fund performance is linked with fund

managers' selectivity remains unanswered and represents the main objective of this study. In this paper

we ask the following natural question: Does fund management selectivity lead to superior fund

performance across the European fund industry?

This paper attempts to fill this void by addressing this question using a unique dataset from 11

European countries. Unlike several previous studies that have investigated the determinants of the

performance of the European mutual fund industry at a very macro level, we investigate whether fund

management selectivity, an established measure of fund management skill, is associated with superior

fund performance for actively managed equity mutual funds.

1,2

In addition, research focus on the more

interesting question of whether European skilled fund managers can generate superior risk-adjusted

excess returns has received considerably less research attention thus far.

3

To the best of our knowledge,

no study has dealt with the measurement of mutual fund managers' skill (i.e., fund selectivity) in a

European context to examine whether superior fund performance is related to fund management skill.

The aim of our analysis is to address this important question.

Empirical studies based on the US mutual fund industry show that mutual fund managers with high

managerial skills improve fund performance by selecting valuable stocks (Carhart, 1997; Daniel et al.,

1997; Gruber, 1996; Zheng, 1999). Fund selectivity skill has been attributed to fund managers'

superior analytical ability to anticipate macro or micro fundamental information (Kacperczyk,

Van Nieuwerburgh, & Veldkamp, 2011) or special knowledge of specific industries or companies

(Cohen, Frazzini, & Malloy, 2007; Kacperczyk et al., 2015). Petajisto (2013) uses active share, which

is measured as the aggregate stockholding dispersion between a manager's portfolio and the benchmark

1

For example, Grünbichler and Pleschiutschnig (1999) and Otten and Bams (2002), conducting aggregate research on the

European mutual fund industry's performance, report that, unlike the evidence of US mutual funds, European mutual funds

as a group slightly outperform the market benchmark. Banegas, Gillen, Timmermann, and Wermers (2013) report that

European mutual fund performance can be explained by macroeconomic state variables, such as the default yield spread,

the term spread, and the dividend yield. Ferreira et al. (2013), using the data of actively managed equity mutual funds from

27 countries, find that both fund-level variables and country characteristics can determine fund performance. In addition,

they show that the superior performance of mutual funds is associated with countries with highly liquid markets and strong

legal investor protection.

2

Several studies, such as Dermine and Röller (1992), Shukla and van Inwegen (1995), Blake and Timmermann (1998),

Dahlquist, Engström, and Söderlind (2000), and Cesari and Panetta (2002) focus on specific European countries.

3

Abinzano, Muga, and Santamaria (2010) use stochastic dominance techniques to show that some European mutual fund

managers do possess management skills. Cuthbertson, Nitzsche, and O'Sullivan (2008) employ a cross-sectional bootstrap

methodology and find that some top-performing UK equity mutual fund managers have stock-picking abilities.

Furthermore, Franck and Kerl (2013) point out that European fund managers actively change their portfolio allocations

based on sell-side analyst information and that this strategy benefits fund performance.

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