Accrual Quality, Skill, and the Cross-Section of Mutual Fund Returns

• In Event: Effect of Investors on Stock Returns

Abstract

Prior research finds that although poor accrual quality (AQ) stocks have higher expected returns (e.g. higher implied cost of capital) they do not earn higher realized returns ex-post. This discrepancy may result from higher expected returns of poor AQ stocks being on average offset by negative news about their deteriorating fundamentals. If future fundamentals deteriorate only for some poor AQ stocks, the AQ premium should re-appear in realized returns after excluding such stocks from the sample. We use returns on actively managed mutual funds as a natural setting that allows testing this conjecture without introducing a look-ahead bias. If (1) fund managers are able to avoid investing in stocks with deteriorating future fundamentals and (2) poor AQ commands a risk premium, then mutual fund portfolios consisting of stocks with worse average AQ should generate abnormally high realized returns. Our results are consistent with these joint hypotheses. Funds that hold stocks with worse AQ earn significantly higher returns after controlling for differences in investing styles and risk exposures. Moreover, the AQ premium is larger in portfolios selected by highly skilled managers who should be better able to avoid stocks with deteriorating fundamentals. Additional results are consistent with the risk explanation for our findings. Specifically, the AQ risk factor based on mutual fund returns has a significantly positive premium in two-stage asset pricing tests.

Authors

• Suresh Nallareddy, Columbia University

• Maria Ogneva, University of Southern California