Mutual Fund’s R^2 as Predictor of Performance

Abstract

We propose that fund performance is predicted by its R^2, obtained by regressing its return on the Fama-French-Carhart four benchmark portfolios. Lower R2, or higher idiosyncratic risk relative to total risk, measures selectivity or active management. We show that lagged R2 has significant negative predictive coefficient in predicting alpha or Information Ratio. This is consistent with Cremers and Petajisto’s (2008) results on the effect of selectivity. Funds ranked into lagged lowest-quintile R2 and highest-quintile alpha produce significant alpha of 2.8%. Also, both fund RMSE and return volatility predict the following year’s performance with significant positive and negative coefficients, respectively. Across funds, R^2 is an increasing function of fund size and a decreasing function of its age, its manager tenure and its past performance, but better performance induces funds to subsequently increase their R^2.