Abstract
We show that, rather than maintaining a constant style, active equity funds alter their factor loadings over time. Style changes are larger following quarters in which funds either substantially under- or out-perform other funds based on returns or fund flows, which is explained by managers both not correcting the resulting passive style drift and deliberately reallocating a portion of the portfolio. Motivated by this observation, we identify a new measure of manager skill, which we call “tactical investment skill.” It captures a manager’s ex-ante observable ability to increase future returns through loadings changes. We show that high-skill managers outperform their low-skill peers in the following month in terms of raw returns and alphas. This outperformance is more pronounced following quarters with large loadings changes.
•Mutual funds change factor loadings after quarters with large under/out-performance.•Style changes arise from both active portfolio reallocations and passive style drift.•We propose a new measure of manager skill, “tactical investment skill.”•This skill captures the ability to increase fund returns through style changes.•High-skill managers continue to outperform low-skill peers in the future.