A Method for Assessing Stock-Picking Wisdom

SMITH BRAIN TRUST – What stocks do the smartest fund managers love, and are they worth knowing?

Recently exploring this question, Investors Chronicle revisited a 2012-published study by Maryland Smith’s Russell Wermers showing mutual fund managers, in aggregate, have better stock selection abilities than other investors. 

Through the work, “Forecasting Stock Returns Through an Efficient Aggregation of Mutual Fund Holding” at the Review of Financial Studies, Wermers and co-authors Tong Yao (University of Iowa) and Jane Zhao (PanAgora Asset Management) show stock selection information produced by fund managers through fundamental research is distinct from the information contained in publicly available and traditionally quantified accounting information.

The following excerpt from Investors Chronicle, the Financial Times’ weekly magazine, deconstructs the Wermers team’s method toward answering its question.

“Another interesting bit of research into fund manager stock picks pitted the skills of top-performing managers against those of underperforming managers. Russ Wermers of the University of Maryland, Tong Yao of the University of Iowa and Jane Zhao of PanAgora Asset Management devised a way of rating shares based on the performance records of the fund managers holding them. The team constructed portfolios where each stock got a positive weighting based on how popular it was with top-performing fund managers offset by a negative weighting for its popularity with poorly performing fund managers. So stocks that were popular with top fund managers and overlooked by poorly performing managers would get a higher weighting in the portfolios and vice versa.

“The researchers described their experiment as ‘a magnifying glass on the collective stock-picking wisdom of fund managers.’ Based on 27 years of data to the end of 2006, the researchers found the top 10 percent of stocks outperformed the bottom by over 4 per cent a year. The stocks that ranked highly among top-performing fund managers were also found to be more likely to deliver positive earnings surprises in the future. This would seem to suggest that, even if the average fund manager can show skill in selecting their top holdings, the top holdings of the best performing fund managers are likely to be of more interest.

“…The good news is that research suggests the performance of portfolios based on lagged information is normally not too different from performance based on more timely information. Indeed, in the case of the Wermers, Yao, Zhao research already cited, the performance was ‘only slightly weakened’ when lagged to reflect public disclosure of holdings. More to the point, these ideas are there to provide a strong kick-off point for research rather than an end in themselves.”

The article, "What are the smartest fund managers' most loved stocks, and are they worth knowing?” can be accessed in full by subscribers.

Wermers, the Dean's Chair in Finance at the University of Maryland’s Robert H. Smith School of Business, is also the director of Maryland Smith’s Center for Financial Policy. His earlier research, more broadly, has developed new approaches to measuring and attributing the performance of mutual funds, pension funds, and hedge funds, as well as devising strategies for investing in these funds. 

Last year, the Securities and Exchange Commission selected him to serve on its new Asset Management Advisory Committee, formed to offer advice and recommendations to the SEC on its new Asset Management Advisory Committee, formed to offer advice and recommendations to the SEC on how regulations and industry trends impact investors.