The Value Added by Trading Based on Valuation Criteria

• Author: Lydia Mateos,Laura Andreu,José Luis Sarto
• DOI: http://doi.org/10.1111/irfi.12097
• Published date: 01 September 2017
• Date: 01 September 2017

The Value Added by Trading Based

on Valuation Criteria*

LAURA ANDREU,LYDIA MATEOS AND JOSÉ LUIS SARTO

Department of Finance and Accounting, University of Zaragoza, Zaragoza, Spain

ABSTRACT

We investigate the value added by active mutual fund management by exam-

ining a comprehensive database of monthly trades of equity mutual funds be-

cause understanding how managers add value for their clients is important in

the current context of a growing fraction of individual investors delegating

their portfolio management to professional managers. We find that the value

added by trading based on valuation criteria outperform trading decisions

motivated by other reasons such as liquidity and taxes. This finding is ob-

tained using both the measures previously proposed by financial literature

as well as some refinements proposed here to evaluate the role of mutual

funds' cash level as well as the interdependence between buying and selling

decisions. In addition, mutual funds that trade based on valuation criteria

more frequently outperform funds that follow this type of trading occasion-

ally. The results are consistent with the notion that active mutual funds on

average fail to outperform passive benchmarks and only a subset of funds

have skilled managers.

JEL Codes: G23

I. INTRODUCTION

This paper sheds light on the value added by active mutual fund managers when

their trading is based on valuation criteria that is when they make dispropor-

tional buys in time periods with money restrictions (the portfolios are suffering

large outflows without cash excess) or sells when they are not constrained by

money outflows or by the maintenance of a minimum cash level. Analyzing a

comprehensive database of monthly portfolio holdings, we find that these trades

lead funds to perform significantly better than their counterparts.

* The authors would like to thank the participants of the XXIII Finance Forum and 22

nd

Annual Con-

ference of the Multinational Finance Society as well as participants of the NIPE Seminar at University

of Minho (Portugal). The authors also acknowledge the financial support provided by Gobierno de

Aragón/Fondo Social Europeo (Grant 268-S14/2 ‘Construyendo Europa desde Aragón‘) and by the

Spanish Department of Science Grant ECO2013-45568-R. Any possible errors contained in this paper

are the exclusive responsibility of the authors.

© 2016 International Review of Finance Ltd. 2016

International Review of Finance, 17:3, 2017: pp. 327–352

DOI: 10.1111/irfi.12097

These results are line with recent literature that demonstrates the superior

ability of active mutual funds. Chen et al. (2000), Alexander et al. (2007),

Cremers and Petajisto (2009), Baker et al. (2010) and Jiang et al. (2014) find sup-

port for the hypothesis of trading skills of mutual fund managers. Thus, although

the average fund portfolio does not outperform the benchmark (see, e.g., Jensen

1968; Daniel et al. 1997; Fama and French 2010), there is evidence that trades are

made with an element of skill.

To enable more powerful tests of the stock-selection abilities of fund man-

agers, the abovementioned studies highlight the importance of analyzing mutual

fund trades instead of fund return or portfolio holdings. Hence, we first examine

the performance of stocks traded by comparing the subsequent performance of

the stocks bought and sold. This analysis will provide us a general idea about

the stock-picking abilities of fund managers.

The structure of open-end funds leads managers to trade based on valuation

criteria but also for other reasons. Unanticipated money flows force managers

to continually rebalance their portfolios to control liquidity. Warther (1995)

and Edelen (1999) argue that open-end fund managers have to provide liquidity

to investors. They are thus obligated to make investment decisions to manage the

liquidity; consequently, they underperform their benchmark because of the

transaction costs. Second, the desire to minimize taxable distributions creates

incentives for them to sell losers heading into the tax year end. Moreover, to im-

press investors, managers may window-dress their portfolios by buying recent

winners and selling recent losers just before reporting dates.

Hence, the aim of the study is to isolate trading decisions by active funds de-

pending on the underlying motivation that leads managers to trade. We compare

the performance consequences of mutual fund whose trades are based on valua-

tion criteria with respect to the remaining reasons to trade. If active mutual funds

trade to exploit their stock-picking abilities or information advantages, the trades

based on valuation beliefs should add more value to fund performance than

those trades carried out by other reasons.

To isolate fund portfolios for which trading activity relies on valuation criteria,

we first follow the approach of Alexander et al. (2007) of examining both the

trading activity of the fund manager (buys and sells) and the fund investment

flows. The analysis of the inflows/outflows to the fund is important because out-

flows increase managers' urgency to sell more than inflows do to buy, which of-

ten leads to erosion in the portfolio performance (Christoffersen et al. 2007).

A manager's purchase of a certain amount of a given security that is perceived

as underpriced if the mutual fund is receiving money inflows is completely differ-

ent from purchasing it in a context of money outflows. In the first case, the buy-

ing decision can be motivated by valuation criteria but also to control the

liquidity of the portfolio. However, in the second case, the buying decision is

clearly based on valuation criteria because the manager has money restrictions

and in spite of that he/she buys the security. Thus, the aim of this analysis is to

provide evidence of stock-picking abilities among active fund managers when

trades are mainly based on valuation criteria.

International Review of Finance

© 2016 International Review of Finance Ltd. 2016328