Predictive power of Brazilian equity fund performance using R2 as a measure of selectivity

Abstract

This paper aimed to investigate the impact of levels of selectivity on the performance of equity funds using a methodology applied for the first time ever (as far as we know) in the Brazilian market. As an indicator of the activity level of a fund, we proposed the coefficient of determination (R2) of the regression of its returns over market returns. In total, 867 funds were analyzed in the period between November 2004 and October 2014. The hypothesis tested is that more selective funds perform better to compensate for their higher operating costs. This hypothesis was confirmed in the Brazilian market. Dynamic equally-weighted portfolios of funds were simulated, according to their past R2 and alphas, with monthly rebalancing and 12-month moving windows. The portfolio of the most selective funds had a Sharpe ratio of 0.0494, on a monthly basis, while the portfolio of the least selective funds had a Sharpe ratio of -0.0314. Performance was also higher in evaluations involving excess returns, Jensen’s alpha, and accumulated returns, as well as when compared to randomly selected portfolios. Moreover, past performance (as measured by Jensen’s alpha) was also a predictor of future performance. Particularly, the portfolio composed by funds with a higher past alpha and lower past R2 presented a Sharpe ratio of 0.1483 and a Jensen’s alpha of 0.87% (significant at 1%), while the one composed of funds with a lower past alpha and lower activity level presented a Sharpe ratio of -0.0673 and an alpha of -0.32% (also significant at 1%).