Finance Cluster Seminar: David Hunter
We analyze the economics of R2's return predictability. Correlations between idiosyncratic returns of portfolio assets, which we call 'Residual Correlation', explain the predictability of R2 much better than its remaining components, namely portfolio concentrations in, and average portfolio exposures to idiosyncratically volatile assets. Our results suggest that fund managers that show return predictability do so by holding many assets that share common exposures to either unmodeled common risk factors or unmodeled abnormal return events.
Thus, abnormal return persistence in these funds could result from either skill or unmodeled risk. Regardless, we show that by attributing R2's predictability into its component parts, residual correlation can identify abnormal return predictability in a broader variety of mutual fund objectives. Residual correlation outperforms R2's prediction of abnormal returns in situations where peer funds share similar idiosyncratic volatility exposures, such as exists among closet index and sector funds.