Marcin Kacperczyk, Stijn van Nieuwerburgh, and Laura Veldkamp
Time-Varying Fund Manager Skill
Journal of Finance | Volume 69, Issue 4 (Aug 2014), 1455-1484

Do fund managers have investment skill? If so, what is the nature of this skill? Previous literature thought about market timing and stock picking as separate and immutable skills that once present, should manifest themselves in every trading period. The evidence of such immutable skill is controversial. Contrary to this premise, we show that the ability of funds to time the market and pick stocks varies over the business cycle. The findings suggest that skill is a general cognitive ability that can be used in different ways - to pick profitable stocks or to time the market - at different times. When we measure skill, allowing its manifestation to change in booms and recessions, we find stronger evidence that a subset of managers indeed possesses skill.

Measuring Skill and Its Business Cycle Dependence

Investors use skill to form portfolios that outperform the average investor. We decompose this outperformance into two categories: If an investor times the market, he earns excess returns by being more exposed to the market portfolio in periods when the realized market return ends up being high and being less exposed when the realized market return is low. Stock picking means the investor earns excess returns by holding more of a stock in periods when its realized return ends up high. Thus, Timing (Picking) skill is measured as a covariance of the portfolio weights today with the systematic (idiosyncratic) component of realized returns in the next period.

The main premise of our paper is that skill manifests itself in a time-dependent fashion. To test this claim empirically, we compare fund manager skill over the business cycle: during booms and recessions. Our definition of business cycles follows that of National Bureau of Economic Research (NBER) but the results we report are qualitatively similar for other measures of economic conditions, including measures that are available in real time.

Using the data on portfolio holdings and returns of the universe of U.S. equity mutual funds (1980-2005), we compute skill measures for each fund in each month. The data set, from Thomson Reuters and CRSP, includes 3477 distinct funds and 250,219 fund-month observations. The number of funds in each month varies between 158 in May 1980 and 1670 in July 2001.

To test the significance of the relationship between skill and business cycles, we estimate the linear regression model, in which we relate each measure of skill (Timing and Picking) individually to an indicator variable (Recession), equal to one any time the economy enters the NBER recession period, and zero otherwise. We control for several fund features that might correlate with business cycles and skill, such as: fund age, assets under management, expenses, turnover, net flow, load fee, and style measures (size, value, and momentum).

Main Results

The main results document the highly cyclical use of skill. On average, Timing is 1.67 percentage points per year higher in recessions than in expansions, whereas Picking is 1.75 percentage points per year lower in recessions. In both cases, this amount of skill represents excess fund returns of about 14 basis points per month. The results remain similar if we measure skill at the fund manager rather than fund level, which suggests that the skill is largely a fund-manager attribute. Even though our results point to strong time-variation in measured skills for an average fund in our sample, a closer look reveals that the effect is largest for the most successful funds: The effect of Recession on Timing for extremely successful managers is about four times larger than that for the median manager, with a (return) difference of 2.3% per year. The effect on Picking doubles.

In another test, we find that it is actually the same manager who has a high level of Timing skill in recession that has also a high level of Picking skill in booms. This result indicates that applying skills indeed changes in a time-dependent fashion.

Implications for Fund Investors

The last result also suggests that some managers may outperform other funds in a consistent fashion. We test this claim formally by selecting a subset of 25% of funds with the highest level of Picking skill in expansions and comparing the performance of this group to a passive investment strategy. Depending on the passive benchmark specification, we find that these funds outperform their passive benchmarks by 48 to 82 basis points per year, an economically significant margin.

The group of outperforming funds is signified by being younger, of smaller AUM, and more active in its investment strategies. Its managers are also more likely having an MBA degree, and ultimately are more likely to be hired by hedge fund companies, thus underscoring their success in the mutual fund business.

In our final set of results, we attempt to predict who a successful fund manager might be. Following the idea that the most successful managers display picking skill in expansion and timing skill in recession, we define an individual Skill Index that weighs each manager's Timing and Picking according to the real-time probability of being in a recession. Thus, Timing receives greater weight in the Index when a recession is more likely. We show that our Skill Index can identify funds/managers which will outperform the market in the subsequent 1-12 months: A fund with a Skill Index value that is one standard deviation above the average value outperforms the average fund by 1-2% per year.

Economic Interpretation

Our findings raise the following questions: Why does picking skill seem to be present in booms, while in recessions any ability to pick stocks vanishes? Why do managers who are effective market-timers in recessions lose that ability in booms? In a theoretical companion paper entitled “A Rational Theory of Mutual Funds' Attention Allocation,” we examine how a fund manager with limited ability to observe or process information should allocate his attention between stock-specific and aggregate shocks. The model teaches us that paying attention to and learning about the aggregate state is most valuable in recessions because there are times when aggregate shocks are relatively more volatile and the market price of aggregate risk is high. The model predicts that, in booms, a skilled manager should allocate more attention to stock-specific shock and will therefore be more successful at stock picking. Similar attention allocation theories have been used to explain a variety of other economic phenomena, including portfolio under-diversification (Van Nieuwerburgh and Veldkamp, RES 2010), portfolio home bias (Van Nieuwerburgh and Veldkamp, JF 2009), and capital income inequality (Kacperczyk, Nosal, and Stevens, NBER 2014).


The findings in our paper touch on fundamental issues such as market efficiency, the dynamics and cross-section of equity returns, as well as what practical portfolio advice to give households. The results also point to a new understanding of what funds do and how they add value for investors. The theoretical framework paints a new picture of what a fund manager who has limited ability to process financial information should do to maximize investor value. Of course, there are many frictions that could distort managers' incentives. But it is still useful to have a clear idea of what the undistorted, efficient manager's investment strategy would look like. The theory offers a host of new testable predictions to contribute to the debate on fund skill and the role of delegated portfolio management in financial markets. In future work, our findings and our framework can be used to analyze the effects of fund entry, rising information processing capacity, or long-run shifts in aggregate or idiosyncratic volatility.