Factor Exposure Variation and Mutual Fund Performance

We investigated the relationship between a mutual fund’s variation in factor exposures and its future performance. Using a dynamic state-space version of the Carhart (1997) four-factor model to capture factor variations, we found that funds with volatile factor exposures underperform funds with stable factor exposures by 147 bps a year. This underperformance is explained neither by volatile factor loadings of a fund’s equity holdings nor by a fund’s forced trading through investor flows. We conclude that fund managers voluntarily attempt to time factors but are unsuccessful at doing so.