Investing in mutual funds when returns are predictable

This paper forms investment strategies in US domestic equity mutual funds, incorporating predictability in (i) manager skills, (ii) fund risk loadings, and (iii) benchmark returns. We find predictability in manager skills to be the dominant source of investment profitability-long-only strategies that incorporate such predictability outperform their Fama-French and momentum benchmarks by 2 to 4%/year by timing industries over the business cycle, and by an additional 3 to 6%/year by choosing funds that outperform their industry benchmarks. Our findings indicate that active management adds significant value, and that industries are important in locating outperforming mutual funds. (c) 2006 Elsevier B.V. All rights reserved.