Residual Correlation, Active Management, and Fund Performance

49 Pages Posted: 11 May 2015 Last revised: 2 Apr 2019

See all articles by Wei Huang

Wei Huang

University of Hawaii at Manoa - Shidler College of Business

David L. Hunter

University of Queensland

Trang Phan

Augustana College

Date Written: May 11, 2015

Abstract

We present "Residual Correlation", the weighted average of pair-wise correlations of asset residual returns, as a unifying measure of mutual fund active management. By decomposing portfolio idiosyncratic volatility into variance and covariance terms, we construct our "Residual Correlation" measure. We propose that skillful fund managers will anticipate positive unsystematic return events. By exposing their portfolios to those events, their portfolios will show correlated returns that are independent of common risk factors. Therefore, "Residual Correlation" captures the return effects of fund managers' bets on correlated idiosyncratic returns of individual assets and active management should be revealed through these correlated asset returns. We show that our measure can identify active management as precisely as various other measures of active management and that it also does so among groups of funds where other measures cannot.

Suggested Citation

Huang, Wei and Hunter, David L. and Phan, Trang, Residual Correlation, Active Management, and Fund Performance (May 11, 2015). Asian Finance Association (AsianFA) 2015 Conference Paper, Available at SSRN: https://ssrn.com/abstract=2605046

Wei Huang (Contact Author)

University of Hawaii at Manoa - Shidler College of Business ( email )

2404 Maile Way
Honolulu, HI 96822
United States
808-956-7679 (Phone)
808-956-9887 (Fax)

David L. Hunter

University of Queensland ( email )

United States
733468094 (Phone)

HOME PAGE: http://https://www.business.uq.edu.au/staff/david-hunter

Trang Phan

Augustana College ( email )

2001 S. Summit Ave.
Sioux Falls, IL 57197
United States

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