Academic journal article Financial Services Review

Stock Selection Based on Mutual Fund Holdings: Evidence from Large-Cap Funds

Academic journal article Financial Services Review

Stock Selection Based on Mutual Fund Holdings: Evidence from Large-Cap Funds

Article excerpt

Abstract

In this study, we investigate whether individual investors should consider the weightings mutual fund managers place on the stocks held in their funds when making stock selection decisions. Specifically, we compare the performance of the stocks that are most heavily weighted in mutual funds versus the stocks that are most lightly weighted. We find that the heavily weighted stocks in mutual funds perform no better than, and sometimes significantly underperform, the most lightly weighted stocks. These results contradict the idea that individual investors can earn excess returns by following the implicit stock selection picks of mutual fund managers-particularly short-term and momentum investors who trade large-cap stocks. Our findings rather suggest that individual investors should be wary of investing in stocks that are the top holdings in general equity mutual funds. © 2004 Academy of Financial Services. All rights reserved.

JEL Classification: G11; G23

Keywords: Portfolio choice; Information and market efficiency; Mutual funds

1. Introduction

In this study, we investigate whether individual investors should consider the weightings mutual fund managers place on the stocks held in their funds when making stock selection decisions. Specifically, we compare the performance of the most heavily weighted stocks in a sample of mutual funds versus the most lightly weighted stocks from the same sample of funds. Finding that the heavily weighted stocks outperform the lightly weighted stocks would suggest that mutual fund managers are superior stock-pickers, and that individuals should take these weightings into consideration when selecting stocks for their portfolios. Our findings do not support this idea, however. Using stocks chosen from large-capitalization blended mutual funds sampled during the most recent bull and bear market periods, we find that the stocks mutual fund managers weight most heavily perform no better than, and sometimes significantly underperform, the most lightly weighted stocks in their funds.

Both academics and practitioners are divided on the issue of whether or not the recommendations of security analysts can be used by investors to generate excess returns. As Barber et al. (2001) point out, brokerage houses spend large sums of money on analysis "... presumably because these firms and their clients believe its use can generate superior returns." The possibility of using analysts' recommendations for profitable trading is suggested by Stickel (1995) and Womack (1996), who find that announcements of favorable (unfavorable) changes in analysts' recommendations result in immediate positive (negative) stock price changes. Womack (1996) further documents that the direction of these price changes persists for anywhere from one to six months subsequent to the announcement.

The view that security analysis generates profitable recommendations is further supported by the findings of Baumann et al. (1995), who examine analyst recommendations appearing in the "Heard on the Street" column of The Wall Street Journal. They find that following the advice of investment analysts leads to superior performance over the ensuing six- and 12-month periods. Rich and Reichenstein (1993) find that individuals investing in large capitalization stocks who use an expected market risk premium based on Value Line's price appreciation potential and expected divided yield can successfully time the market. Mann and Solberg (1991) devise a variety of stock screening strategies, also based on a risk premium, that are effective in generating returns that exceed those achieved by professional money managers. Gold and Lebowitz (1999) use stock screening software and various filters to form portfolios that handily beat their comparative benchmarks. Ferreira and Smith (2003) find that the investment recommendations made by panelists on "Wall Street Week" are profitable. These studies and others suggest that stock selection strategies cannot be dismissed out-of-hand. …

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