Zigging: Funds that invest against the herd see better performance

A new study from the University of Iowa finds that so-called contrarian investment funds far outperform their herd-fund rivals in several performance measurements, and that their mangers have found ways to gather information that other managers haven’t figured out.

The study, “Uncommon Value: The Characteristics and Investment Performance of Contrarian Funds,” looked at the investment habits of mutual funds that invest in stocks or stock sectors that have fallen out of favor by other managers. For instance, a contrarian investor would have shunned technology stocks during the dot-com boom of the late 1990s, while buying them during the dot-bomb bust that followed. Or they may have ignored financial companies that exploded in value as the housing bubble inflated prior to 2006, then bought stocks in that sector after the credit markets froze in 2008.

Study co-author Tong Yao, associate professor of finance in the Henry B. Tippie College of Business, pointed out that many contrarian fund managers go on to become celebrities, such as Peter Lunch, Warren Buffet, and John Templeton.

The researchers first defined a contrarian fund by analyzing the stock trades of more than 73,000 actively managed U.S. stock funds between 1995 and 2012 and ranked them on a contrariness scale based on how many zig trades they made while other managers zagged. Because this analysis was based on actual stock trades, the researchers found that some funds that call themselves contrarian actually aren’t because their trades mostly tracked the herd. Conversely, some funds that do not call themselves contrarian actually are.

Their analysis found that contrarian funds tended to be more successful than herd funds, a performance reflected in higher cash inflows and higher Morningstar ratings.

But the research found that not only did contrarian funds outperform herd funds overall, they outperformed them by 2 percent when investing in the same stock sectors that herd managers were investing in. In other words, contrarian managers beat the herd managers at their own game.

So why do contrarian funds outperform other funds? The researchers ran tests that ruled out other sources—such as different forms of price pressure or public pronouncements of companies to investors—but none seemed to have an effect. Another analysis ruled out dumb luck.

In the end, the researchers say, the likeliest source of the contrarian managers’ success was that they’re better than other managers at finding relevant information that gives them an edge in determining which out-of-favor stocks will soon be back in favor. Yao says that would explain why contrarian managers may trade with or against herd managers—their trades are based on private information, not on a reflexive trade against herd managers.

Yao says his research team doesn’t have a definite answer as to what information sources those managers use. The value of the company may have something to do with it―book-to-market ratios, for instance―but those don’t seem to fully explain the phenomenon. One speculation is that the managers combine those types of traditional valuation signals with observations of what other investors are doing, such as dumping or buying a stock as an overreaction to those signals.

The researchers also found a predictive quality to contrarian funds, as the stocks held in contrarian funds tended to perform better in the four quarters after the manager purchased it.

Yao’s paper was co-authored by Kelsey Wei of the University of Texas at Dallas and Russ Wermers of the University of Maryland. It will be published in a forthcoming issue ofManagement Science.

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