Mutual Funds and Stock Fundamentals

• In Event: Market efficiency and anomalies
  In Paper Session: Market Efficiency and Anomalies

Abstract

Many papers in the accounting and finance literature show that stocks of firms with strong fundamentals generate positive market-adjusted returns. Using one fundamental screen (the F_SCORE strategy developed by Piotroski [2000]), we add to this literature in several dimensions. First, we show that abnormal returns are generated in practice after transaction costs, price pressure effects, and management fees when trading on firm fundamentals. Using net returns for actively managed mutual funds we find that the CAPM alpha, the 3 factor alpha, the 4 factor alpha and the Sharpe Ratio increase for mutual funds as the fraction of their portfolio held in fundamentally strong stocks increases. Second, we show that portfolios of stocks with strong fundamentals have lower total risk, lower idiosyncratic risk, lower systematic risk and similar returns as fundamentally weak stocks. Third, we show that compared to the market, actively managed mutual funds on average do not slant their portfolios towards fundamentally strong stocks as measured by the F_SCORE, even in the years following the publication of Piotroski [2000]. This finding is intriguing since mutual funds who happen to hold fundamentally stronger stocks generate positive and significant alphas and higher Sharpe Ratios in practice. The results are consistent with probability distortion as is predicted by prospect theory or with manager incentives that focus on relative returns instead of risk-adjusted returns.

Authors

• Qiyuan Peng, Tulane University

• Sheri Tice, Tulane University

• Ling Zhou, The University of New Mexico