Can a Realistically Constrained Fund Manager Beat the Benchmark Index Using Anomaly-Based Strategies?

Abstract

This paper examines whether a realistically constrained fund manager can outperform the benchmark index using trading strategies based on asset pricing anomalies. I consider a fund manager who faces the following realistic constraints on his investment activity: abnormal performance and tracking error are measured relative to a benchmark index, and short positions are prohibited. The manager implements size, book-to-market and momentum strategies by over-weighting small, value or winner stocks and under-weighting large, growth or loser stocks relative to the benchmark index. When the fund manager uses the Fama-French SMB, HML and UMD portfolio weights as the guide for implementing these size, book-to-market and momentum strategies the investment portfolio does not outperform the benchmark. However, alternative size, book-to-market and momentum strategies do outperform the benchmark in some circumstances. However, the performance is far less impressive than the performance of investment portfolios based on long-short anomaly portfolios. When the Russell 3000, a common real-world benchmark for fund managers, is used as the benchmark index, size and book-to-market strategies are unable to provide excess performance, while momentum strategies do. I conclude that long-only constraints and tracking error are significant real-world impediments to successfully implementing profitable strategies from the academic literature.

Keywords: active management, long-short