All but the most devout “efficient market” theorists agree that some mutual fund managers beat the market with greater consistency than others. But identifying them is another matter altogether, particularly as a large part of the return on any manager’s portfolio reflects luck, not skill, says Malcolm Baker, a professor at the Harvard Business School.

In order to identify the skill component, Baker and several colleagues studied the earnings announcements of stocks that mutual fund managers in the U.S. had bought, comparing these with earnings from stocks that had been sold.

The authors of Can Mutual Fund Managers Pick Stocks?, published on the National Bureau of Economic Research’s Web site (www.nber.org), looked at all fund holdings data for U.S. funds between the second quarter of 1980 and the third quarter of 2002. They then collated the earnings announcements that followed each stock’s filing with the Securities and Exchange Commission.

Future earnings announcement returns on the stocks that managers had bought were, on average, considerably higher than the future earnings announcement returns on the stocks that they had been selling, the authors concluded. Moreover, certain types of managers were more likely to get things right than others.

Managers who do better are more likely to have a style that focuses on growth rather than income, Baker found. In addition, funds that are larger, have a higher turnover and use incentive fees show better performance.

Although the study doesn’t address whether active mutual fund managers can regularly produce additional returns large enough to exceed the fees they charge, it does suggest that fund managers are more likely to think for themselves — and, therefore, potentially outperform — when their pay is closely linked to their funds’ performance.

Other researchers concur. In an April 2003 Journal Of Finance study entitled Incentive Fees and Mutual Funds, professors Edwin Elton and Martin Gruber of New York University and professor Christopher Blake of Fordham University’s Graduate School of Business concluded that, on average, incentive-fee funds return 1% more per year than similar funds without these fees — albeit with slightly more risk. Interestingly, they also discovered that funds with incentive fees frequently charge lower fees on average than other funds, which is one of the reasons they tend to outperform other funds.

In an unrelated 2005 study entitled Compensation and Managerial Herding: Evidence from the mutual fund industry, Massimo Massa and Rajdeep Patgiri, finance professors at the INSEAD business school in France, also maintain that performance incentives can have a positive impact on fund managers’ buying and selling decisions. Their research suggests that managers whose compensation is significantly enhanced if they meet certain performance hurdles are also more likely to beat the market benchmark.

Conversely, those who are paid a declining percentage of assets under management have the least incentive for good performance, and this is reflected in their returns. Managers whose compensation is a flat percentage of assets under management generally fall in the middle of performance rankings, they add.

To support this, Massa and Patgiri calculated how various incentives affected managers’ decisions to buy technology stocks in the late 1990s. They found that managers with the most significant performance incentives tended to steer away from these high-flying companies, lagging most funds in the three-year period leading up to the technology sector meltdown, and outperforming them over the subsequent three years.

The point here is that incentive-driven compensation affects managers’ willingness to buy and sell the same stocks that others are trading because those least rewarded for good performance tend to be more worried about being absolutely wrong rather than finishing at the top of the relative rankings. This means that they will be more likely to mimic other funds’ portfolios, something that Kingsley Fong, a professor at the University of New South Wales, has labelled “herding behaviour.”

Massa also maintains that pay-for-performance managers are more likely to invest in stocks that are out of favour — something that was most evident during a bubble such as that of the late 1990s. However, their later results frequently validate their decisions, moving them ahead of the herd.

So, should investors search out funds that are supported by performance-based incentives? Only if they are willing to end up with portfolios that look significantly different from the average fund.

@page_break@Recently, investors have been impatient with Canadian equity funds that did not load up on energy stocks, dumping them along the way. However, sticking with a currently low-ranked fund in the hope of outperforming over the longer term may prove worthwhile — particularly if the manager has a larger stake in the results than his or her peers. E