Want to know if a fund manager is skilled? Watch the tough days in the market

Finding skilled fund managers who can outperform the market is hard. It is so hard that many investors simply follow past performance to pick active fund managers, even though this is not a good way to find skilled managers. But even professional investors fall into this performance chasing trap. Since investors like to chase past performance, let me tell you about a way to identify skilled managers based on past performance.

Sami Badidi and his collaborators used high frequency daily website traffic data for fifteen financial data websites to measure investor attention paid to individual funds in the US. Then they matched this web traffic data with weekly fund flows for a total of almost 2,000 funds to see under what circumstances investors looked at their mutual funds and how flows reacted to short-term performance on specific days or weeks.

The top graph in our chart shows the average weekly fund flows for funds based on their relative performance vs. the entire fund universe. Funds that outperform on any given day tend to experience net inflows in the coming week while underperforming funds lose a little bit of their assets. That is just performance chasing on a daily basis.

Mutual fund flows as a function of relative fund performance (Panel A) and on the worst 5% of all market days (Panel B)

Source: Badidi et al. (2024)

Where things get interesting is the lower graph in our chart which shows fund flows in the week after the 5% worst days in the market. The shift from underperforming funds to outperforming funds is even more pronounced than normal. This is not so much because investors shift more of their assets but because investors are more likely to check their portfolios on bad days in the market. If the market is down a lot, many investors cannot resist checking their performance. Then they look at the performance of fund X in their portfolio and if that fund is down even more than the market, they are very likely to sell these holdings and move it into a fund that has outperformed on that day.

What was news to me, though, is that the study found that shifting from underperforming funds to outperforming funds on a bad day is performance-enhancing. Funds that outperform significantly on bad days in the market are significantly more likely to outperform in the long run. The authors find “that managers with the skill to outperform on the 5% of days with the worst market returns generate about as much unconditional future outperformance as managers with the skill to outperform on the remaining 95% of days”. That is a strong finding because it essentially says that true skill reveals itself in tough markets.